The Delhi bench of the Income Tax Appellate Tribunal ("Tribunal"), in the case of Convergys Customer Management Group Inc. v ADIT1, has held that frequent visits of the employees of the foreign company together with continued supervision and control over such employees and assumption of majority of the risks of the business by the foreign company would give rise to Permanent Establishment ("PE") under Article 5 of the India-US tax treaty ("Treaty"). More crucially, in order to address the ambiguity created by the tax authorities while determining the profits to be allocated to such PE, the Tribunal laid down a multi-factored formula for attribution of profits to a PE in India.
Convergys Customer Management Group Inc. ("Assessee") is a company incorporated in the United States of America ("US") that provides IT enabled customer management services and is entitled to claim benefit as a tax resident of the US under Article 4 of the Treaty. The Assessee has a subsidiary in India by the name of Convergys India Services Private Ltd. ("CIS") that provides procurement services in the nature of IT enabled call center/back-office support to the Assessee on a principal to principal basis. The Assessee has no business activity in India and undertook majority of the risk related to the procurement services such as market price, R&D, service liability risk etc. As the Assessee's customers were foreign, it assumed that the risk was present outside India.
The Assessing Officer ("AO") held that the Assessee had a fixed base PE, a service PE and a dependent agent PE in India and attributed profits by allocating the global revenue in proportion to the number of employees as opposed to the actual revenue. The learned Commissioner of Income Tax (Appeals) ("CIT (A)") modified the AO's holding on appeal and provided that the Assessee had only a fixed place PE in India and attributed profits based on end-customer revenue submitted by the Assessee, but allowed deduction for only a part of the expenses in the nature of R&D, expenditure, depreciation, amortization incurred outside India. Moreover, the CIT (A) held that profits further to the arm's length price were to be attributed on account of employees seconded, assets provided and risks managed by the Assessee in relation to the entrepreneurial services. The CIT (A) also questioned whether reimbursement of payments for software financial reporting packages and link charges would amount to 'royalty' under Section 9(1)(vi) of the Income Tax Act, 1961 ("ITA"), with the former being affirmed by the CIT (A) Aggrieved by such order, the Assessee and the Revenue both preferred an appeal to the Tribunal.
RULING OF THE TRIBUNAL
The Tribunal, after hearing all contentions put forth by the parties, arrived at the following conclusions:
PE exposure: The Tribunal held that the Assessee had a fixed base PE as under Article 5(1) in India owing to two factors:
- Frequent visits of the Assessee's employees to CIS in India for the purpose of supervision, direction and control of CIS's activities; and
- Such employees had a fixed place of business at their disposal.
In addition, the Tribunal noted that CIS was a projection of the Assessee in India and complete exercise of control and guidance was exercised by the Assessee without assuming or subsuming any significant risk in relation to these functions undertaken.
Attribution of profits to the PE: The Tribunal upheld the finding of the CIT (A) that end-customer revenue is to be considered the starting point for attribution and rejected the approach of the AO where global revenue in proportion to the quantum of employees was considered. The Tribunal relied on the relevant CBDT Circular2 and the Apex Court decision in DIT v Morgan Stanley3 and held that there can be no further attribution of profits to a PE once an arm's length price has been determined in accordance with transfer pricing principles. Applying the said principle, it was held that no further attribution could be done owing to assets provided, employees seconded or risks managed. As the Assessee did not prepare India specific accounts, the attribution of profits as per the Transfer Pricing study was not accepted and therefore, the profit-split method was held to be inappropriate.
The Tribunal proceeded to lay down a step by step methodology for attribution of profits to a PE as under:
- Global operating income percentage as per the annual report/10K of the company is to be computed;
- Operating income from Indian operations is to be arrived at by applying this percentage to end-customer revenue in regard to projects where services were acquired from the Indian outfit;
- This operating income is to be reduced by the profit before tax of the Indian outfit and the residue attributable to the Indian PE would be considered the profit attributable to it.
- As determined under Step 3 above, the profit attributable to the PE should be estimated on residual profits.
Profit of Indian PE = Operating income from Indian operations - Operating income of Indian subsidiary
On the issue of residual profit attribution, the Tribunal weighed the approaches used in two Apex Court decisions - Anglo French Textile Company Ltd. v CIT4 where 10% attribution was held reasonable and Hukum Chand Mills Ltd. v CIT5 where 15% attribution was held reasonable and held that 15% attribution would meet the ends of justice in the case at hand.
With regard to the expenses, the Tribunal reversed the finding of the CIT (A) and allowed complete deduction for all expenses irrespective of the expenses incurred by the PE or the parent company in accordance with paragraph 3 of Article 7 of the Treaty.
Characterization of payments for software and link charges: The Tribunal upheld the Mumbai Tribunal's decision in B4U International Holdings v DCIT6 and the Delhi High Court decision in DIT v Nokia Networks OY7 and held that notwithstanding the fact that the scope of Section 9 of the ITA had been broadened vide Finance Act 2012, the purchase of software would fall within the category of copyrighted article and would not be taxable as 'royalty' under Article 12 of the Treaty.
Moreover, the payment of link charges was held not to constitute royalty for the use of equipment as there was no transfer of the 'right to use' either to the Assessee or to CIS. It was held that mere procurement and furtherance of provision of service, as usually done when link charges are paid, does not involve leasing of any equipment and therefore, could not be termed royalty and taxed as the same. Even otherwise, it was held that these payments were in the nature of reimbursements and hence, were not taxable.
In an interesting decision, the Tribunal, after upholding that attribution to a PE must be done as per transfer pricing principles, has used a formulary approach which is a deviation from the conventional arms' length price approach used in India. While most arms' length price determination methods work on a case-to-case basis, a formulary approach seeks to apply a pre-determined formula for all taxpayers. Under Indian tax law, an approach similar to a global formulary approach has been envisaged under Rule 10 of the Income Tax Rules, 1962, wherein an AO has been given the power to use such approach where he feels that the actual amount of income accruing or arising (from whatever source it may be) cannot be ascertained. However, in the event the taxpayer has completed the Functions, Assets and Risks analysis and made comprehensive transfer pricing documentation, the AO should not go for the formulary approach8.
Globally, there seems to be no consensus in favour of the global formulary approach due to difficulty in implementation and factors such as disregard of present market conditions and practical difficulties9 and therefore, the preferred modes have been the arm’s length price methodologies. In the instant case, although the profit-split method has been rejected, no reasoning as to why a formulary approach has been adopted is provided; this creates ambiguity as to what approach the taxpayer should adopt.
Interestingly, the decision of the Tribunal reiterates the principle that when a treaty is operative between two countries involved in a software purchase, the amended Section 9(1)(vi) would be rendered otiose owing to non-fulfillment of criteria given in the Treaty. Furthermore, the issue of link charges is largely unexplored in India as yet and this decision would provide relief to taxpayers who are involved in similar arrangements owing to the finding that such payments do not tantamount to equipment royalty.