Month: December

GENERAL TESTS FOR DETERMINING EMPLOYER-EMPLOYEE RELATIONSHIP

The IT Act does not define the term ‘employment’. It also does not overlook the concept of economic employment, as well. Hence, the distinction between legal employment and economic employment and the principles for determination of economic employment would be relevant for the purposes of the Income-tax Act (IT Act).

We may discuss the various decisions in the context of the IT Act and other statutes which have laid down the tests to determine whether there exists an employee-employer relationship. Some of these decisions are discussed below:

• In Lakshminarayan Ram Gopal & Son Ltd. vs. Government of Hyderabad (1954) 25 ITR 449 (SC), it has been held that the word ‘employment’ connotes the existence of a jural relationship of master and servant between the employer and the employee, that is, between the person paying and the person paid.

• In East India Carpet Co (P) Ltd. vs. Its Employees 1970 Jab LJ 29, 31; it has been held that the term ‘employment’ involves a concept of employment under a contract of service. In DC Works Ltd vs. State of Saurashtra (1957) SCR 152 (SC), it has been held that the greater the amount of direct control exercised over the person rendering the services by the person contracting them, the stronger the grounds for holding it to be a contract for service.

• In Silver Jubilee Tailoring House vs. Chief Inspector Of Shops And Establishments 1974 AIR 37 (SC), for drawing a distinction between a contract for service (employment) and contract of service (independent contractor), the Court has highlighted the importance of the degree of control and supervision of the employer or the person employing such services. It has been held that if an ultimate authority over the worker in the performance of his work resided in the employer so that he was subject to the latter’s direction, that would be sufficient. A reference may also be made to the decision in Shivnandan Sharma vs. Punjab National Bank Ltd., (1955) 1 SCR 1427:AIR 1955 SC 404:(1955) 1 LLJ 688. The test of control and supervision has also been applied in the undernoted¹  cases.

• A person exercises supervisory control over another’s work; and

• The former exercises the ultimate authority over the latter’s work in so far as the former gives directions to the latter specifying the manner in which the work is to be carried out and the latter is bound by such directions.

SUPREME COURT’S DECISION IN MORGAN STANLEY’S CASE

In appeal, while examining whether a Service PE exists within the meaning of Article 5(2)(l) of the DTAA, the Court in paragraph 14 ruled that the said Article applies in cases where the MNE furnishes services within India and those services are furnished through its’ employees. Thus, where employees are deputed by MSCO in India for providing services to MSAS, the Court held that MSAS constitutes a Service PE. The Court has given due credence to the control and supervision exercised by MSCO on the employees deputed in India through whom it provides services in India to MSAS. Based on the same, the Court has concluded that MSAS constitutes a Service PE for MSCO in India.

Though the ratio is in the context of Service PE under the provisions of the DTAA, it is relevant for determination of the economic employer in the case of deputation. This is for the reason that a Service PE would be constituted in India where a foreign entity renders services in India through its’ employees in India. Thus, for a Service PE to be constituted, the deputationist must continue to remain the employee of the foreign entity even post such deputation.

The said test of control and supervision laid down by the Hon’ble Supreme Court for determining whether the deputationist continues to remain the employee of the foreign entity is in line with the test discussed in the earlier segment.

Having ruled so, in paragraph 15, the Hon’ble Court went on to lay down the following propositions of law:

(i)    On deputation, the employee of MSCO, when deputed to MSAS, does not become an employee of MSAS.

(ii)    The 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.

(iii)    Where the activities of the multinational enterprise entail it being responsible for the work of deputationists and the employees continue to be on the payroll of the multinational enterprise or they continue to have their lien on their jobs with the multinational enterprise, a service PE can emerge.

(iv)    On request/requisition from MSAS, MSCO 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)(1).

Thus, it may be noted that the Hon’ble Supreme Court has provided the following parameters to treat a deputationist/expat as the employee of the foreign entity:

• A deputationist shall have a lien on his employment with foreign entity;

• The foreign entity retains control over the deputationist’s terms and employment at the time of deputation; and

• A Service PE emerges where the activity of the foreign entity requires it to be responsible for the work of deputationists, and the deputationists continue to be on the payroll of foreign entity or have their lien on their jobs with the foreign entity.

Thus, it may be noted that while in paragraph 14, the Court emphasized only the control and supervision exercised by the foreign entity on the deputationist, in paragraph 15, it has brought out two aspects i.e., lien exercised by the deputationist on his employment with the foreign entity, and the foreign entity being responsible for the work of the deputationist. The second aspect i.e., being responsible for the work, may subsume into the test of control and supervision adumbrated in paragraph 14.

However, it is pertinent to note that while the Court has laid down the twin tests of control and supervision over the work [thus being responsible thereof] of deputationists and the exercise of lien by the deputationists as relevant tests, it has not discussed as to which of the two tests would have greater precedence over the other.

The issue that arose before the Court was whether the secondment of employees by the overseas entities would amount to Fees for Technical Services or Fees for Included Services within the relevant DTAAs in question, which would embody the concept of a Service PE.

In order to drive home the point that the seconded employees were under the employment of CIOP, it was argued on behalf of CIOP that the seconded employees would work under the direct supervision and direction of the board and management of CIOP. It was also argued that it was convenient for them to receive salaries overseas. An option available to such employees was to receive their salaries through India and later transfer their salaries overseas. However, to avoid the same, the employees continued to remain on the payroll of the overseas entities who would disburse the salaries. Thereafter, the petitioner would reimburse such salary costs to the overseas entities. Thus, the primacy of concept of economic employment as opposed to legal employment was argued to contend that for, all practical purposes, CIOP is the economic employer. The reasons attributed to defend this contention were that the entire direction and supervision over the seconded employees was under its control and the pay and emoluments were borne by it.

While negating the argument on behalf of the Petitioner, the Court ruled that the overseas entities rendered services through the seconded employees to CIOP. Thus, the Court ruled that even post the secondment, the employees continued to remain the employees of the overseas entities on the following grounds:

(i)    The service provided by the secondees is to be viewed in the context in which their secondment or deputation was necessitated. The overseas entities required the Indian subsidiary, CIOP, to ensure quality control and management of their vendors of outsourced activity. For this activity to be carried out, CIOP required personnel with the necessary technical knowledge and expertise in the field, and thus, the secondment agreement was signed since CIOP – as a newly formed company – did not have the necessary human resource.

(ii)    The secondees are not only providing services to CIOP, but rather also tiding CIOP through the initial period, and ensuring that going forward, the skill set of CIOP’s other employees is built and they continue these services without assistance. In essence, the secondees are imparting their technical expertise and know-how onto the other regular employees of CIOP. The activity of the secondees is thus to transfer their technical ability to ensure quality control vis-à-vis the Indian vendors, or in other words, ‘make available’ their know-how of the field to CIOP for future consumption.

(iii)    While the Court agreed that the seconded employees were under the control and supervision of CIOP, there was no purported employment relationship between CIOP and the secondees. None of the documents, including the attachment to the secondment agreements placed on record (between the secondees and CIOP) revealed that the latter can terminate the secondment arrangement; there is no entitlement or obligation, clearly spelt out, whereby CIOP has to bear the salary cost of these employees. The secondees cannot in fact sue CIOP for default in payment of their salary – no obligation is spelt out vis-à-vis the Petitioner.

(iv)    All direct costs of such seconded employee’s basic salary and other compensation, cost of participation in overseas entities’ retirement and social security plans and other benefits in accordance with its applicable policies and other costs were ultimately paid by the overseas entity. Whilst CIOP was given the right to terminate the secondment, (in its agreement with the overseas entities) the services of the secondee vis-à-vis the overseas entities – the original and subsisting employment relationship – could not be terminated. Rather, that employment relationship remained independent, and beyond the control of COIP.

(v)    The employment relationship between the secondee and the overseas organisation is at no point terminated, nor is CIOP given any authority to even modify that relationship. The attachment of the secondees to the overseas organization is not temporary or even fleeting, but rather, permanent, especially in comparison to CIOP, which is admittedly only their temporary home.

(vi)    The social security, emoluments, additional benefits, etc. provided by the overseas entity to the secondee, and more generally, its employees, still govern the secondee in its relationship with CIOP.

(vii)    Whilst CIOP may have operational control over these persons in terms of the daily work and may be responsible (in terms of the agreement) for their failures, these limited and sparse factors cannot displace the larger and established context of employment abroad.

(viii)    The Court placed reliance on the Commentary of Klaus Vogel, wherein it was noted that the situation would have been different if the employee works exclusively for the enterprise in the State of employment and was released for the period in question by the enterprise in his state of residence. The Hon’ble High Court considered that this factor was critical to determine the economic employer.

From the above, it may be noted that the High Court, with due respect, has erred in giving higher weightage to the latter of the twin tests laid down by the Hon’ble Supreme Court in Morgan Stanley’s case (supra), i.e. exercise of lien by the seconded employee on its’ employment with the overseas entities. The High Court may not be correct in stating that limited and sparse factors of operational control over the secondees by CIOP in terms of their daily work and its’ responsibility for their work would not displace the larger and established context of employment abroad.

Further, while the counsels for Petitioner argued as to the concept of economic employment and relied on the degree of operational control exercised by CIOP, it appears that satisfaction of the twin conditions as laid down by the Hon’ble Supreme Court was not highlighted before the High Court. Had the Petitioner highlighted the importance of the said twin conditions, the ratio laid down by the High Court may have been different.

The petitioner’s SLP before the Hon’ble Supreme Court was dismissed in Centrica India Offshore Pvt. Ltd. vs. CIT [SLP (C). No 22295/2014, dated 10th October, 2014. Further, a review petition filed was also dismissed in Centrica India Offshore Pvt. Ltd. vs. CIT [RP(C) No. 2644 of 2014 in SLP (C). No 22295/2014, dated 10th December, 2014].    

(i)    IDS-USA was the legal employer. Since the assessee-company was to reimburse the emoluments paid by IDS-USA to him, it was the assessee-company which for all practical purposes was to be looked upon as the employer of ‘S’ during the relevant period;

(ii)    The person who actually controlled the services of ‘S’ was the assessee-company. Under the secondment agreement, ‘S’ was to act in accordance with the reasonable requests, instructions and directions of the assessee-company. He would have to devote the whole of his time, attention and skills to the assessee-company. He was to report to and be responsible to the assessee-company;

(iii)    The assessee-company could remove ‘S’ before the expiration of the period of his office. The board of directors of the assessee-company regulated the powers and duties of ‘S’ by passing appropriate resolutions;

(iv)    The seconded employee is required to also act as an officer or an authorised signatory or nominee or in any other lawful personal capacity for the assessee-company, which would also be out of place in an agreement for rendering technical services; and

(v)    Therefore, it was held that seconded employee was responsible and subservient to the assessee-company, which could not be the case if the agreement was for providing technical services by IDS to the assessee-company.

2. (2009) 122 TTJ 410 (Bang); relied on in ITO vs. M/s Cerner Health Care Solutions Pvt. Ltd [I.T.(T.P.) A.No.1509/Bang/2012];  ITO vs. Ariba Technologies (India) Pvt. Ltd [I.T.A. No.616(Bang.)/2011]; Caterpillar India Pvt. Ltd vs. Deputy Director of Income-tax [ITA 629/630/606/607/149/(Bang)/2010]; DCIT vs. Mahanagar Gas Ltd. [2016] 69 taxmann.com 321 (Mumbai – Trib.)

In AT & T Communication Services (India) (P.) Ltd vs. DCIT [2019] 101 taxmann.com 105 (Delhi – Trib.), it was held by the Tribunal that the nature of income embedded in related payments is relevant for deciding whether or not section 195 will come into play and so long as a payment to non-resident entity is in the nature of payment consisting of income chargeable under the head ‘Salaries’, the Indian Company does not have any tax withholding applications u/s 195 of the Act. The Tribunal distinguished the case before it from Centrica India’s case (supra) and observed that seconded employees of foreign company were not taking forward the business of foreign company in India. In Centrica (Supra), the employees were seconded to Indian company to ensure that services to be rendered to the overseas entities by the Indian vendor are properly coordinated.

In DIT vs. Abbey Business Services Ltd. (2020) 122 taxmann.com 174 (Kar), the assessee was a subsidiary of ANITCO Ltd. a group company of Abbey National Plc, UK (ANP). ANP had entered into an agreement with the assessee, to outsource the provision of certain process and call centers to M/s. Msource India Pvt. Ltd. Under the agreement, Msource India Pvt. Ltd was required to provide high quality services which supports the position of ANP and its affiliates as well as to customers in UK. To facilitate outsourcing agreement between ANP and Msource India Pvt. Ltd., an agreement for secondment of staff was entered into between ANP and the assessee on 4th February, 2004. For deputation of its employees, Abbey, India had made certain payments to ANP, part of which was salary reimbursement on which tax was deducted. The question arose whether such payments amounted to fees for technical services. The Court ruled that the reimbursement of salary costs by the Appellant was not FTS as the employees in question were employees of the assessee. The Court took into consideration the aspect of control, direction and supervision exercised by the assessee. The Court also observed that the employees were required to function in accordance with the policies, rules and guidelines applicable to the employees of the assessee. The Court has distinguished the judgement in Centrica’s case (supra) on the grounds that the question of permanent establishment was not involved in the case on hand, unlike in Centrica’s case (supra). With due respect, such basis is incorrect given that even in Centrica’s case, the question for consideration was whether costs reimbursed by petitioner therein to the overseas entity was FTS/FIS within the meaning of the DTAAs in question, which was also the question before the Karnataka High Court in Abbey’s case (supra).

From the above extracted paragraphs, it can be noted that the Honourable Supreme Court has concluded that the seconded employees were not the employees of the assessee company in India by taking into consideration the following aspects:

• The nature of the overseas group companies’ business is providing certain specialized services (back office, IT, bank related services, inventories, etc. which can be performed by its highly trained and skilled personnel.

• Taking advantage of the globalized economy and location savings, the Overseas group company had assigned, inter alia, certain tasks to the assessee, including back-office operations of a certain kind, in relation to its activities, or that of other group companies or entities.

• As part of this agreement, a secondment contract is entered into, whereby the overseas company’s employee or employees, possessing the specific required skill, are deployed for the duration the task is estimated to be completed in. Thus, the employees were deployed to the assessee, on secondment in relation to the business of the overseas employer and the group.

• Though the employee was in control of the assessee and the assessee had the power to terminate the services of the seconded employees, upon expiry of the secondment period, the employees would return to their overseas employer.

• The Overseas employer pays them the salary. The terms of employment, even during their secondment, are in accord with the policy of the overseas company who is the employer.

• The fact that the assessee had to ultimately bear the burden of salaries of the seconded employees was irrelevant as the seconded employees were performing the tasks in relation to the assessee’s activities and not in relation to the overseas employer.

After discussing various decisions laying down the traditional test of supervision and control, the Court has indicated that such traditional test to indicate who the employer is may not be the sole test to be applied.

The above decision, in contrast to the decisions of the twin tests laid down in Morgan Stanley’s case (supra) has brought out a new perspective i.e. whose business the seconded employee is carrying on? The decision lays down the principle that where the Indian entity provides support or back-office services to the foreign entity and the seconded employees enable the company to provide such services efficiently and effectively through their expertise, the employees continue to remain in employment of the foreign entity though their functions may be under the control and supervision of the Indian entity.

The said principle appears to be in line with the facts and the ultimate ratio in Centrica’s case (supra) and also the basis on which other decisions as cited in paragraph 5 have distinguished the ratio in Centrica’s case (supra).

• Clause 1.5 of the Master Service Agreement (MSA) defines the scope of work relating to secondment.

• Clause 3.1 of the MSA provides that the Petitioner may terminate the services of the secondees.

• Clause 4.2 provides that the party placing the secondees can invoice the party receiving the service, the secondment costs, expenses and incidental costs borne in the Home Country.

• Even though Walmart Inc. has the power to decide the continuance of the services in USA of the seconded employees after the termination of their secondment in India, it would relate to a service condition post the period of secondment. What would be of significance is the relationship between the petitioner and the seconded employee.

• The equity eligibility of the seconded employee which was a pre-existing benefit (even prior to the secondment) ought not to alter the relationship of employer and employee between the petitioner and the employee.

• Further, mere payment by Walmart Inc. to the seconded employees would not alter the relationship between the petitioner and the seconded employees, as the petitioner only seeks to make payment to Walmart Inc. of its payment to the seconded employees which is stated to be by way of reimbursement.

• The Petitioner was not merely acting as a back office for providing support service to the overseas entity, whereby the overseas entity could be treated as an employer.

• The Petitioner issues the appointment letter, the employee reports to the petitioner and the petitioner has the power to terminate the services of the employee.

The Court also rejected the revenue’s reliance on the decision in Northern Operating’s case (supra) by distinguishing the case on hand from the facts in the said case, on the following grounds:

• The Apex Court has interpreted the concept of a secondment agreement taking note of the contemporary business practice and has indicated that the traditional control test to indicate who is the employer, may not be the sole test to be applied. The Apex Court while construing a contract whereby employees were seconded to the assessee by foreign group of Companies, had upheld the demand for service tax holding that in a secondment arrangement, a secondee would continue to be employed by the original employer.

• The Apex Court in the particular facts of the case had held that the Overseas Co., had a pool of highly skilled employees and having regard to their expertise were seconded to the assessee and upon cessation of the term of secondment would return to their overseas employees. While returning such finding on facts, the assessee was held liable to pay service tax for the period as mentioned in the show cause notice.

• The judgment rendered was in the context of service tax and the only question for determination was as to whether supply of manpower was covered under the taxable service and was to be treated as a service provided by a Foreign Company to an Indian Company. But in the case on hand, the legal requirement requires a finding to be recorded to treat a service as ‘FIS’ which is “made available” to the Indian Company.

Though the said decision is in the context of provisions of Service Tax, the decision lays down certain important principles to determine whether or not the seconded employee remains the employee of the foreign entity even after such secondment or deputation to the Indian entity. Hence, the principles laid down thereunder would equally apply even in the context of provisions of the Income- tax Act.

While the decision in Morgan Stanley’s case (supra) was rendered by a division bench of the Hon’ble Supreme Court, the decision in Northern Operating’s case (supra) is rendered by a larger bench of 3-judges. Thus, the interesting question for consideration is whether the twin tests laid down in Morgan Stanley’s case (supra) are sacrosanct or have they been diluted in terms of the ratio in Northern Operating’s case (supra).

• While the Court has referred to its’ earlier decision in Morgan Stanley’s case (supra) in its’ subsequent decision in Northern Operating’s case (supra), it has not doubted the twin tests laid down thereunder or dissented from the ratio laid therein.

• As discussed earlier, the subsequent decision in Northern Operating’s case (supra) has stated that the traditional test of control and supervision for determination of the economic employer cannot be the sole test. Even in Morgan Stanley’s case (supra), the test of control and supervision was not the sole and determinative factor but was part of twin tests. Thus, on this count, the decision in Northern Operating’s case (supra) appears to be line with the decision in Morgan Stanley’s case (supra).

• A fortiori, the twin tests laid down in Morgan Stanley’s case (supra), continue to hold the field even post the decision in Northern Operating’s case (supra) and are still relevant given that they have been laid down in the specific context of the Income-tax Act read with the relevant DTAAs.

Northern Operating’s case (supra) was rendered in the context of sections 65(68) and (105)(k) of the Finance Act, 1994 dealing with ‘supply of manpower’ prior to amendment in 2012 (with effect from 1st July, 2012) and section 65B(44) of the Finance Act, 1994 defining the term ‘service’ post such amendment. Thus, on the interpretation of such provisions, the Court ruled that the service of supply of manpower was rendered by the overseas entities to the appellant therein. However, in the context of Income-tax Act read with the relevant DTAAs, it would be necessary for the department to establish that the services, if any, rendered by the overseas entity through its’ employees would amount to technical services or included services as per the provisions of the IT Act read with the relevant DTAA, before any liability can be imposed.

The Commentary on Article 15 of the OECD Model Tax Convention recognizes the principles of real or economic employment in contradistinction to legal employment. It lays down the following tests or factors for determination of economic employment:

• The hirer does not bear the responsibility or risk for the results produced by the employee’s work;

• The authority to instruct the worker lies with the user;

• The work is performed at a place which is under the control and responsibility of the user;

•  The remuneration to the hirer is calculated on the basis of the time utilized, or there is in other ways a connection between this remuneration and wages received by the employee;

• Tools and materials are essentially put at the employee’s disposal by the user;

• The number and qualifications of the employees are not solely determined by the hirer.

In the Commentary by Professor Klaus Vogel on ‘Double Taxation Conventions,’ it has been observed that where an employee is sent abroad to work for a foreign enterprise as well, the foreign enterprise does not qualify as an employer merely because the employee performs services for it or because the enterprise was issuing to the employee instructions regarding his work or places or tools at his disposal. However, it has been highlighted that the situation would be different if the employee works exclusively for the enterprise in the State of employment and was released for the period in question by the enterprise in his State of residence.

The above commentaries lay down the tests to be applied to determine the economic employer, which would be relevant for the purposes of the Income-tax Act read with the DTAAs and may not be relevant for the purposes of the Service Tax Act. Hence, these commentaries were not considered by the Hon’ble Supreme Court in Northern Operating’s case (supra). However, for the purposes of provisions of the Income-tax Act, the tests laid down in the said commentaries would be relevant. The Supreme Court in Engineering Analysis Centre Of Excellence P. Ltd. vs. CIT (2021) 432 ITR 471 chose to apply principles canvassed by OECD in the absence of contrary provisions in the domestic law.

The above commentaries would indicate while the test of control and supervision may be a relevant test, it may not be sole determinative factor, more so when the employee does not work exclusively for the Indian entity to whom he has been deputed and continues to carry on the business of the foreign entity. This is the key aspect which has also been emphasized by the Delhi High Court in Centrica’s case (supra) as highlighted earlier.

This also appears to be the sentiment of the decision in Northern Operating’s case (supra). Thus, the key takeaway from the decision in Northern Operating’s case (supra) and on reconciling the same with various earlier decisions of the Hon’ble Supreme Court including the one in Morgan Stanley’s case (supra) is that supervision and control exercised by the Indian entity would by itself not be determinative. Where the Indian entity is itself under the supervision and control of the foreign entity and carries on the business of the latter, mere supervision and control exercised by the Indian entity over the seconded/deputed employees would be irrelevant. In such circumstances, the seconded employees would be enabling the Indian entity in carrying on the business of the foreign parent in a more efficient and effective manner.

Thus, an analysis would have to be made in each case whether post such secondment/deputation, the seconded/deputed employee is carrying on the business of the foreign entity or is solely serving the Indian entity to whom he has been seconded/deputed. It is only in the latter situations, coupled with the supervision and control exercised by the Indian entity, one may be able to conclude that such person is the employee of the Indian entity during such period of secondment/deputation. This proposition is in line with the Commentary on Article 15 of the OECD Model Tax Convention and Commentary by Klaus Vogel, laying down the tests for determination of economic employer, which appear to be the distinguishing factor as taken into account by the High Court in the decision in Centrica India’ case (supra).

Thus, after such deputation/secondment, where the employee is exclusively devoted to the Indian entity and does not carry on the business of the foreign entity, he can be said to be under the economic employment of the Indian entity. In such circumstances, it would be possible for the Indian entity to distinguish its’ case from the facts in Northern Operating’s case (supra).

In CIT vs. Eli Lilly & Co. (India) P. Ltd. [2009] 312 ITR 225 (SC), the assessee company, incorporated in India, was a joint venture between M/s. Eli Lilly, Netherlands B.V. and Ranbaxy Laboratories Ltd. The foreign partner had seconded four expatriates to the joint venture in India. They were employees of the joint venture post such deputation or secondment. However, they continued to remain on the rolls of the foreign company. They received home salary outside India from the foreign partner. The Indian venture deducted tax on salary paid to such expats but failed to deduct tax on such home salary. In appeal, the Court held that the Indian joint venture was liable to deduct at source u/s 192 in respect of such home salary which accrued in India under the provisions of section 9(1)(ii) read with the Explanation thereto.

Thus, in the above decision, the Court has understood that the home salary is salary paid by the foreign entity on behalf of such Indian entity. It is for this reason, the Court directed the Indian entity to deduct tax at source from such payments u/s 192. The above judgement, in the specific context of provisions of the Income-tax Act would indicate that where the services are provided by the expatriate post the secondment to the Indian entity, the employee would be under the economic employment of the Indian entity despite the fact that such employees continue to be on the rolls of the foreign entity.

The decision in Eli Lilly’s case (supra) would support the proposition that even where salaries are paid by the foreign entity to the seconded/deputed employees, such employees can be said to be under the economic employment where the services are rendered to the Indian entity during the course of such secondment.

Further, the decision in Eli Lilly’s case (supra) appears to be in line with the principles laid down in the Commentary by Klaus Vogel, laying emphasis on sole employment during the period of secondment, which was considered the most important factor as per the decision in Centrica’s case (supra). This is for the reason that in the judgement in Eli Lilly’s case (supra), there is a finding of fact by the Hon’ble Court that post the deputation, no work was performed by the employees for the foreign company.

Dealing with this exclusivity theory, it may be noted that the concept of simultaneous dual employment is not alien to the Income-tax Act. It has in fact been recognized by section 192(2) of the IT Act, which recognizes that during the financial year, an assessee may be employed simultaneously under more than one employer. Further, in today’s times, with the emergence of concept of moonlighting, certain employers permit their employees to exercise a second employment in so far as such second employment does not affect the business activities of the employer.

In such scenarios, when the provisions of the IT Act recognize such dual employment, it may be possible for the seconded employee to exercise such dual employment, during such period of secondment. Thus, the decision in Northern Operating’s case (supra), rendered in the specific context of the facts therein and more so in the context of provisions of Service Tax, cannot be relied on to insist on exclusivity.

With respect to fee paid to visiting doctors by hospitals, the Revenue³ is often found taking a stand that such payment amounts to salary and that tax is to be deducted by the concerned hospital u/s 192 as against section 194J. This stand is adopted despite the fact that upon any negligence by the doctor, he and not the concerned hospital would be responsible as per the Code of Ethics and the Medical Council Guidelines applicable to such doctors. Thus, in such cases, the responsibility over the work of the doctors by the hospital is overlooked by the department. The department also overlooks the factor of sole employment, given that the doctors may be visiting and providing their services to more than one hospital.

However, in the context of secondment, the revenue is seen taking a completely contradictory argument of sole employment with the Indian entity, for the purposes of determination of economic employment.

3. CIT vs. Grant Medical Foundation [2015] 375 ITR 49 (Bombay); CIT vs. Manipal Health Systems (P.) Ltd. [2015] 375 ITR 509 (Karnataka); CIT vs. Teleradiology Solutions Pvt Ltd [2016-TIOL-703-HC-KAR-IT];  ITO vs. Dr. Balabhai Nanavati Hospital [2017] 167 ITD 178 (Mumbai); Hosmat Hospital (P.) Ltd. vs. ACIT [2016] 160 ITD 513 (Bangalore – Trib.). Note that the authors have only named a few cases herein.

1. BACKGROUND
At the outset, one admits that very limited literature is available in respect of this anti-abuse rule as most discussions on the MLI, at least in the Indian context, focus on the Principal Purpose Test (‘PPT’) and the amendments to the rules relating to the constitution of a PE. However, the anti-abuse rule for PEs situated in third jurisdictions can have significant implications, especially for an Indian payer undertaking compliance u/s 195 of the Income-tax Act, 1961 (‘the Act’), given the amount of information required to apply this rule.

Under this rule, the Source State can deny treaty benefits to taxpayers on certain conditions being triggered. Such treaty benefits can be in the form of a lower rate of tax (as in the case of dividends, royalty, fees for technical services) or in the form of narrower scope (such as the narrower definition of royalty under the treaty or the make-available clause). Therefore, when one is undertaking compliance u/s 195, one would need to evaluate the impact of this rule.

While a detailed evaluation of the impact on India has been provided subsequently in this article, before one undertakes an analysis of the anti-abuse rule it is important to understand how the taxation works in the case of a PE in a third state, i.e., in triangular situations and the abuse of treaty provisions that this rule seeks to address.

1.1 Basic structure and taxation before application of the said rule
For the purpose of this article, let us take a base example of interest income earned by A Co, a resident of State R, from money lent to an entity in State S and such income earned is attributable to the PE (say a branch) of A Co in the State PE as it is effectively connected with the activities of the PE. A diagrammatic example of the said structure is provided below:

In this particular fact pattern, State S being the country of source would have a right to tax the interest. However, such right may be restricted by the application of the R-S DTAA, particularly the article dealing with interest. If the article on interest in the R-S DTAA is similar to that in the OECD Model Convention1, interest arising in State S payable to a resident of State R, who is the beneficial owner of the income, can be taxed in State S but not at a rate exceeding 15% of the gross amount of the interest.

1   Unless specifically
provided, the OECD Model Tax Convention and Commentary referred to in this
article is the 2017 version

Now, State PE, being the country in which the PE of A Co is constituted, will have the right to tax the income of the PE in accordance with the domestic tax laws and in the manner provided in the article dealing with business profits of the R-PE DTAA.

Further, while State PE would tax the profits of the PE, one would apply the non-discrimination article in the R-PE DTAA which generally provides that the taxation of a PE in a particular jurisdiction (State PE in this case) shall not be less favourable than that of a resident of that jurisdiction (State PE). This particular clause in the article would enable one to treat the PE as akin to a resident of State PE and therefore would be eligible to claim the foreign tax credit in State PE for taxes paid in State S2. The OECD Model is silent on whether State PE shall provide credit under domestic tax law or whether it would restrict the credit under the DTAA between State PE and State S. This issue of tax credit, not being directly related to the subject matter of this article, has not been dealt with in detail.

State R being the country of residence, would tax the income of the residence and provide credit for the taxes paid in State S as well as State PE in accordance with the R-S and the R-PE DTAAs.

1.2 Use of structure for aggressive tax planning
Many multinationals use the triangular structure to transfer assets to a jurisdiction which has a low tax rate for PEs and where the residence state provides an exemption for profits of the PE. These structures were typically common in European jurisdictions such as Belgium, Luxembourg, Switzerland and the Netherlands.

A common example is of the finance branch set up by a Luxembourg entity in Switzerland3. In this fact pattern, a Luxembourg entity would set up a branch in Switzerland for providing finance to all the group entities all over the world. Given the fact that a finance branch only required movement of the funds, it was fairly easy to set up the structure wherein the funds obtained by the Luxembourg entity (A Co) would be lent to its branch in Switzerland. This finance branch would then lend funds to all the operating group entities around the world acting as the bank of the group and earning interest. Interest paid by the operating entities would be deductible in the hands of the paying entity and taxed in the country of source in accordance with the DTAA between that jurisdiction and Luxembourg. Further, the Swiss branch, constituting a PE in Switzerland, would be subject to very low taxation in accordance with the domestic tax law in Switzerland.

2   Refer para 67 of the OECD
Model Commentary on Article 24

3   J-P. Van West, Chapter 1:
Introduction to PE Triangular Cases and Article 29(8) of the OECD Model in The
Anti-Abuse Rule for Permanent Establishments Situated in Third States: A Legal
Analysis of Article 29(8) OECD Model (IBFD 2020), Books IBFD (accessed 16^th
November, 2021)

This would result in the interest being taxed in the country of source (with a deduction for the interest paid in the hands of the payer in the country of source) at a concessional treaty rate, very low tax in the country where the PE is constituted, i.e., Switzerland and no tax in the country of residence, i.e., Luxembourg by virtue of the exemption method followed in the Luxembourg-Swiss DTAA.

Like interest, one could also transfer other assets which resulted in passive income such as shares and intangible assets, resulting in a low tax incidence on the dividend and royalty income, respectively.

Let’s take the example of India, where a resident of Luxembourg invests in the shares of an Indian company through a PE situated in Switzerland. In such a scenario, India would tax the dividend at the rate of 10% due to the India-Luxembourg DTAA (as against 20% under the Act), Switzerland may tax the income attributable to the PE at a low rate and Luxembourg would not tax the income in accordance with the Luxembourg-Switzerland DTAA.

The OECD, recognising the use of PE to artificially apply lower tax rates, attempted to tackle this in the OECD Model Convention by providing further guidance on what would be considered as income effectively connected in the PE. For example, para 32 of the 2014 OECD Model Commentary on Article 10, dealing with taxation of dividends, provides,

‘It has been suggested that the paragraph could give rise to abuses through the transfer of shares to permanent establishments set up solely for that purpose in countries that offer preferential treatment to dividend income. Apart from the fact that such abusive transactions might trigger the application of domestic anti-abuse rules, it must be recognised that a particular location can only constitute a permanent establishment if a business is carried on therein and, as explained below, that the requirement that a shareholding be “effectively connected” to such a location requires more than merely recording the shareholding in the books of the permanent establishment for accounting purposes.’

Similar provisions were also provided in the Commentary on Article 11 and Article 12, dealing with interest and royalty, respectively.

However, the above provisions may not necessarily always tackle all forms of tax avoidance. Thanks to the nature of tax treaties applying only in bilateral situations, it may not apply in case of a PE constituted in a third state (State PE). Similarly, one may still achieve an overall low rate of tax by moving the functions related to the activities in the State PE. For example, in the case of a finance branch, one can consider moving the treasury team to State PE with an office, which would constitute a fixed place of business and therefore, the interest income earned from the group financing activities may still be effectively connected to the PE in the State PE.

The OECD Model recognised this limitation and para 71 of the 2014 OECD Model Commentary on Article 24 provides that a provision can be included in the bilateral treaty between the State R and the State S to provide that an enterprise can claim the benefits of the treaty only if the income obtained by the PE situated in the other State is taxed normally in the State of the PE.

1.3 BEPS Action 6
The US was one of the few countries which had provisions similar to the Article in the MLI in its tax treaties even before the OECD BEPS Project. In fact, even though the US is not a signatory to the MLI, the provisions as released by the US were used as a base for further discussion in the BEPS Project. The anti-abuse rule was covered in the OECD BEPS Action Plan 6 dealing with Preventing the Granting of Treaty Benefits in Inappropriate Circumstances.

The objective of the anti-abuse provision is provided in para 51 of the BEPS Action 6 report, which is reproduced below,

‘It was concluded that a specific anti-abuse provision should be included in the Model Tax Convention to deal with that and similar triangular cases where income attributable to the permanent establishment in a third State is subject to low taxation.’

While the language in the MLI is similar to the suggested draft in the final report of the BEPS Action Plan 6, there are certain differences – mainly certain deletions, in the MLI, which have been discussed in detail in the second part of this article.

It is important to note that while Article 10(1) is included in the MLI as a specific anti-avoidance rule, MLI also contains a general anti-avoidance rule under Article 7 through the PPT. Further, in the Indian context, the domestic law also contains anti-avoidance provisions in the form of general anti-avoidance rules. An interplay between all three is discussed in para 3.5 below.

2. STRUCTURE AND LANGUAGE OF ARTICLE 1
2.1 Introduction to Article 10
The language contained in this Article refers to various terminologies that have been defined under Article 2 of the MLI [e.g., Contracting Jurisdiction (‘CJ’), Covered Tax Agreement (‘CTA’)]. Those terminologies referred to in Article 10, which have not been defined under Article 2 of the MLI, have to be interpreted as per Action 6 of Base Erosion and Profit Shifting (‘BEPS’).

Article 10 of the MLI seeks to deny treaty benefits in certain circumstances.

2.2 Structure
Article 10 of the MLI is structured in six paragraphs wherein each paragraph addresses a different aspect related to the anti-abuse provision. The flow of the Article is structured in such a way that the conditions for attracting the provisions of the article are laid down first, followed by the exceptions and finally the reservation and notification which are in line with the overall scheme of the MLI.

To better understand Article 10, it would be beneficial to understand each paragraph individually. Let us proceed as per the order of the article.

Paragraph 1:
Paragraph 1 brings out the conditions for the applicability of Article 10 in certain circumstances:

‘Where:

a) an enterprise of a Contracting Jurisdiction to a Covered Tax Agreement derives income from the other Contracting Jurisdiction and the first-mentioned Contracting Jurisdiction treats such income as attributable to a permanent establishment of the enterprise situated in a third jurisdiction; and

b) the profits attributable to that permanent establishment are exempt from tax in the first-mentioned Contracting Jurisdiction,

the benefits of the Covered Tax Agreement shall not apply to any item of income on which the tax in the third jurisdiction is less than 60 per cent of the tax that would be imposed in the first-mentioned Contracting Jurisdiction on that item of income if that permanent establishment were situated in the first-mentioned Contracting Jurisdiction. In such a case, any income to which the provisions of this Paragraph apply shall remain taxable according to the domestic law of the other Contracting Jurisdiction, notwithstanding any other provisions of the Covered Tax Agreement.’

Each underlined word is a condition for the applicability of the article and has its own significance.

An enterprise – The question as to how to interpret the term ‘an enterprise’ and what comes under the purview of the same is covered in the later part of this article.

derives income from the other Contracting Jurisdiction – This emphasises on the aspect that the income earned by the Resident State should be derived from the State S for the Article to get triggered.

income as attributable to a permanent establishment of the enterprise situated in a third jurisdiction – In addition to the condition as mentioned above, the income derived by the State PE from State S should be treated as attributable to the PE in State PE by State R.

exempt from tax in the first-mentioned Contracting Jurisdiction – This covers the point regarding the taxability of the profits attributable to the PE in the State R. It focuses on the point that Article 10 would be applicable if the profits attributable to the PE are exempt from tax in State R.

tax in the third jurisdiction is less than 60 per cent – This sentence points out the 60% test which states that the tax in the State PE is less than 60% of the tax that would be payable in the State R on that item of income if that PE was situated in the State R.

In case all the above conditions are satisfied, the benefits of the CTA between the State R and the State S shall not apply to such item of income.

The second part of paragraph 1 gives power to the State S to tax the item of income as per its domestic laws notwithstanding any other provisions of the CTA in cases where the provisions of Article 10(1) are satisfied.

Thus, it can be understood that the provisions of Article 10(1) emphasise on the denial of treaty benefits in order to prevent complete non-taxation or lower taxation of an item of income.

Paragraph 2:
Paragraph 2 states the exceptions where the provisions as set out in paragraph 1 of the Article 10 will not be applicable.

The exception covers the income derived from the State S in connection with or is incidental to active conduct of the business carried on by the PE. However, the business of making, managing or simply holding investments for the enterprise’s own account such as activities of banking carried on by banks, insurance activities carried on by insurance enterprises and securities activities carried on by registered securities dealers will not come under the purview of paragraph 1 of the Article. The business of making, managing or simply holding investments for the enterprise’s own account carried on by other than the above-mentioned enterprises shall come under the purview of paragraph 1 of the Article. A detailed discussion on what is considered as active conduct of business is covered in the second part of this article.

Paragraph 3:
Paragraph 3 of Article 10 provides that even if treaty relief is denied due to the trigger of the provisions of
Article 10(1), the competent authority of State S has the authority to grant the treaty relief as a response to a request by the taxpayer in the State R on the basis of justified reasons for not satisfying the requirements of Article 10(1).

In such situations, the competent authority of the State S shall consult with the competent authority of the State R before arriving at a decision.

Paragraph 4:
Paragraph 4 is the compatibility clause between paragraph 1 through paragraph 3 which mentions ‘in place of or in the absence of’.

This means that if there is an existing provision in a CTA which denies / limits treaty relief in instances of triangular cases (‘Existing Provision’), then such a provision would be modified (i.e. in place of) to the extent paragraph 1 through 3 are inconsistent with the existing provisions (subject to notification requirements analysed below).

However, if there is no existing provision then paragraph 1 through 3 would be added to the CTAs (i.e., in absence of).

Paragraph 5:
Article 10(5) covers the reservation aspect to be in line with the overall scheme of the MLI.

This reservation clause is applicable because Article 10 is not covered under minimum standard and hence the scope for reservation is wide. There are three options available to each signatory:
a) Article to not be applicable to all CTA’s in entirety, or
b) Article to not be applicable in case where the CTA already contains the provision as mentioned in paragraph 4, or
c) Article to only be applicable in case of CTA’s that already contain the provisions as mentioned under paragraph 4 (i.e., the existing provisions to be modified to the extent that they are inconsistent with the provisions of Article 10).

Paragraph 6:
Article 10(6) provides the notification mechanism to assess the impact of the reservations and position adopted by the signatories on the provisions of the CTAs.

In cases where the parties decide to go as per sub-paragraph (a) or (b) of Article 10(5), then they need to notify the depository whether each of its CTA contains the provisions as per Article 10(4) along with the article and paragraph number. In case where all contracting jurisdictions have made such a notification, then the existing provisions shall be replaced by the provisions of Article 10. In other cases, such as in the case of a notification mismatch (i.e., one signatory to the CTA does not notify the provisions of Article 10 whereas the other signatory to the same CTA notifies them), the existing provisions shall ONLY be modified to the extent that they are inconsistent with the provisions of Article 10.

India has not made any reservation. Further, India has not notified any DTAAs which have a provision similar to that in para 4 of Article 10. Therefore, the provisions of Article 10 of the MLI shall supersede the existing provisions of the DTAAs to the extent they are incompatible with the existing provisions.

2.3 Reason as to why the Source Country should not grant DTAA benefits
The main policy consideration for implementation of Article 10 of the MLI is to plug the structure wherein one can artificially reduce the overall tax simply by interposing a PE in a low-tax jurisdiction, which is a major BEPS concern.

Tax treaties allocate the taxing rights between the jurisdictions. A Source State giving up its taxing rights is a result of bilateral negotiation with the Residence State. However, if such Residence State decides to treat such income as attributable to a third state and therefore not taxing such income by virtue of another treaty of which the Source State is a not a party, would be against the intention of the countries who have negotiated the treaty in good faith.

Therefore, if State R gives up its right of taxation of income earned from State S due to the artificial imposition of a PE in a third State, Article 10 of the MLI gives the entire taxing right back to State S.

3. SOME ISSUES RELATED TO INTERPRETATION OF PARA 1 OF ARTICLE 10 OF MLI
Having analysed the broad provisions of Article 10 of the MLI, the ensuing paragraphs seek to raise (and analyse) some of the issues in relation to para 1 of Article 10.

3.1 Definition of PE – Which DTAA to Apply
While considering the situation of denial of treaty benefits laid out in the treaty between State R and State S with regard to the income earned by the PE of an entity of the State R in a State PE, there are two DTAA’s that come under this purview, namely:
i. Treaty between the State R and the State S, and
ii. Treaty between the State R and the third state (PE State).

For the purpose of referring to the definition of PE, the first question that arises is which of the two DTAAs has to be referred to? This issue arises mainly because the term ‘Permanent Establishment’ is not a general term but is a specific term which is defined in the DTAA (generally in Article 5 of the relevant DTAA).

A view could be that since the acceptability or denial of benefits under the DTAA between the State R and State S is evaluated and State S is the jurisdiction denying the treaty benefit, one should look at the DTAA between the State R and State S to determine the PE status. However, the objective of the anti-abuse provision is to target transactions wherein income is not taxed in State R due to a PE in State PE. Further, MLI 10(1) applies only if the Residence State treats the income of an enterprise derived from the Source State as attributable to the PE of a third State. This decision of Residence State is obviously on the basis of its treaty with the PE State as it is a bilateral decision. As the Source State is not a party to this decision, the treaty between Residence State and Source State cannot be applied. Therefore, a better view would be to consider the provisions of the DTAA between the State R and the third state (State PE) for the definition of PE.

It is also important to note that prior to introduction of MLI, Article 5 of the DTAA was referred to in order to establish the PE status. However, post introduction of the MLI, one would also need to evaluate the impact of Article 12 to Article 15 of the MLI which covers the PE status based on Action 7 of Base Erosion and Profit Shifting (BEPS). This, of course, is subject to the CTA between Residence State and PE State not reserving the above articles.

3.2 Whether PE jurisdiction needs to be a signatory to MLI
Article 10 of the MLI merely provides that State S should deny benefit of the DTAA between State R and State S if certain conditions are triggered. One of the conditions is that the income is treated by Residence State as attributable to the PE of the taxpayer in State PE. Having concluded the above, that the PE definition under the DTAA between State R and State PE should be considered, it is not necessary that such DTAA is impacted by the MLI. If the DTAA between State R and State PE is impacted by the MLI, one would need to consider the modified definition of PE in such a situation.

Here, it would be important to look at Article 34 of the Vienna Convention on the Law of Treaties, 1969. The same is reproduced below:

Article 34 – General Rule Regarding Third States
A treaty does not create either obligations or rights for a third state without its consent.

In this particular scenario, it is clear that there is no right or obligation granted to the State PE under the DTAA between State R and State S. State PE can continue to tax the profits of the PE.

Further, by signing MLI Article 10, State S and State R should be deemed to have consented their rights and obligations under the State R-State S treaty as amended by MLI Article 10. Consequently, State PE would not be required to be a signatory to the MLI.

3.3 No taxation in country of residence
Another issue which arises is what if the country of residence does not tax the income irrespective of whether the income is attributable to a PE or not. For example, if dividend income is earned by a resident of Singapore and such income is attributable to the PE of the shareholder in a third jurisdiction, such dividend would not be taxable irrespective of whether the dividend is attributable to a PE in a third state or not.

In such a scenario, Article 10 of the MLI should not apply as the tax rate in State PE is not less than 60% of the tax rate in State R. In any case, as the Source State had given up its right of taxation even when the Residence State did not tax such income and imposing a third jurisdiction in the transaction, would not result in a reduction of taxes in the Residence State.

3.4 Interplay of Article 10 with Article 5
Article 5 of the MLI provides for the elimination of double taxation using the credit method as against the exemption method. It refers to three options for preventing double non-taxation situations arising due to the State R providing relief under the exemption method for income not taxed in the State S.

The interplay between Article 5 and Article 10 comes into play because Article 10 is applicable only in cases where the income is exempt in the State R. So, in order to determine whether or not the income is exempt in the State R, Article 5 will have to be referred to. If the DTAA between State R and State PE provides for the exemption method for elimination of double taxation, but State R has opted to apply Article 5 of the MLI, the credit method would apply and in such a situation, in the absence of exemption granted in State R, the provisions of Article 10(1) shall not apply.

India has opted for Option C under Article 5 which allows a country to apply the credit method to all its treaties where the exemption method was applicable earlier. Therefore, with respect to India only credit method will be applicable as a method to eliminate double taxation.

Given that India’s tax treaties apply the credit method for providing relief from double taxation, the situation contemplated under Article 5 may not be relevant in the Indian context.

3.5 Interplay of Article 10 with PPT / GAAR
The Principle Purpose Test (‘PPT’) rule under Article 7 is the minimum standard and applies to all DTAAs covered under MLI. A question could therefore arise as to which provision would override the other. It is pertinent to note that provisions of Article 29 of the OECD Model clearly specify that Article 29 would apply where the PPT has been met. However, Article 10 of the MLI does not lay down any preference of application of PPT or otherwise. Consequently, it could be possible to take a view that if the specific conditions of Article 10 are met, PPT rule should not apply to deny the treaty benefits.

However, a better and sensible view could be that even if the special anti-abuse provision contained in Article 10 is satisfied, the general anti-abuse provision under Article 7(1) also needs to be satisfied to avail treaty benefits. In other words, where the main purpose to set up or constitute the PE in the third state (State PE) was to obtain tax benefit, such an arrangement should be covered under the mandatory provisions of Article 7(1) of the MLI so as to deny the treaty benefits. In a case where the provisions of MLI Article 10 are applicable, the treaty benefits can be denied based on the applicability of MLI Article 10 itself. In other words, MLI article 7(1) and MLI Article 10 both can co-exist and an assessee needs to satisfy both the tests to avail treaty benefits.

Further, in a case where India is the State S, one will also have to see the applicability of GAAR provisions and its interplay with the provisions of Article 10. Typically, GAAR applies where the main purpose of the arrangement is to obtain tax benefit and the GAAR provisions can kick in to deny the treaty benefits as well. Here it is important to note that both Indian domestic law and OECD recognise that the provisions of GAAR / PPT and SAAR / MLI 10 can co-exist. FAQ 1 under Circular 7 of 2017 states that the provisions of GAAR and SAAR can co-exist and are applicable, as may be necessary, in the facts and circumstances of the case. The same has also been recognised under para 2 of the OECD commentary on Article 29.

4. CONCLUSION
In the second part of this article, the authors will attempt to analyse some practical challenges arising on account of the difference in the tax rates of the jurisdictions involved and the impact of the anti-avoidance rule on India. The second part will also cover the difference between Article 10 of the MLI and the BEPS Action Plan 6 Report on the basis of which the rule was incorporated in the MLI and Article 29 of the OECD Model.  

1   BEPS
relates chiefly to instances where the interaction of different tax rules leads
to double non-taxation or less than single taxation. It also relates to
arrangements that achieve no or low taxation by shifting profits away from the
jurisdictions where the activities creating those profits take place – OECD’s
publication on ‘Action Plan on Base Erosion and Profit Shifting’

In line with the above and with the advent of the new framework of documentation, the arm’s length principle (ALP) which was considered to be transaction-based and at most entity-based, has evolved from the entity approach to mapping of the position of the group entities and reconciling the profits allocated according to arm’s length with ‘value creation’. This shift is more so as ALP is seen as being vulnerable to manipulation as it lays emphasis on contractual allocations of functions, assets and risks and this results in outcomes which do not correspond to the value created through the economic activity carried out by the members of the group. Some of the instances of current ALP mismatches are given below:

(a) Benchmarking analysis currently undertaken which considers only one part of the transaction without taking into consideration the holistic analysis of the parties involved in the intercompany transaction.
(b) Commissionaire model wherein the significant people functions contribute highly to the group but draw only a cost plus or fixed return to the entity with the people function.
(c) IP structures without the people function charging royalty to the group entities by claiming to be the legal owner of intangibles while no value creation happens in the said entities.

Hence, for the sustainability of the group’s transfer pricing policy, it becomes necessary to conduct a value chain analysis in order to bridge the gap between the requirements of the existing documentation requirement and the BEPS-driven documentation.

Value chain analysis in simple terms means a systematic way of examining all the activities performed by the business and determining the sources of the competitive advantage which translate into profit for the group. In short, a value chain analysis projects the value creation story of the group by bringing out how and where the value is created and by which entities within the group. This analysis is crucial as it will assist the group to test and corroborate the alignment of the transfer pricing policies with the value creation.

The OECD in its BEPS projects has also recognised value chain analysis as being useful in determining the value drivers and the relevant factors necessary for splitting the profits to the entities creating the value. Further, Actions 8-102: 2015 Final Reports on ‘Aligning transfer pricing outcomes with value creation’ states that the value chain analysis should consider where and how value is created in the operations by considering the following:
(a) Economically significant functions, assets and risks and the key personnel contributing to the same;
(b) The economic circumstances that add to the creation of opportunities to increase profits;
(c) The substance in the value creation and whether the same is sustainable or short-term.

Effectively conducted value chain analysis can lead to transformation in the supply chain in order to align with the value drivers. A value chain analysis thus provides companies with a means to defend their transfer pricing policies, i.e., to prove that the arm’s length price is in sync with the actual functions performed, assets employed and risks assumed.

ORIGIN AND CONCEPT OF VALUE CHAIN
The concept of ‘value chain’ was introduced by Micheal Porter in his book The Competitive Advantage: Creating and Sustaining Superior Performance, back in 1985. In simple terms, it refers to the chain of activities performed by a business to transform an input for a product or service into an output that is of value in the market for the customer. Such activities could range from design and development, procurement, production, marketing, logistics, distribution, to after-sales support to the final customer. These activities may be performed by a single entity or a group of entities which are based in different locations that contribute to the overall profitability of the business.

2   Actions
8 to 10 – Action 8 relates to TP framework for intangibles and cost
contribution agreements, Action 9 relates to TP framework for risks and
capital, and Action 10 relates to TP methods for other high-risk transactions

POST-BEPS – GUIDANCE PROVIDED ON VALUE CHAIN
BEPS is an initiative by the OECD which seeks to ensure that each country gets its fair share of taxes by setting up effective domestic and international tax systems which curb base erosion and profit shifting by multinational corporations by misusing the gaps and mismatches in the present tax systems. As a part of this project, 15 detailed Action Plans were laid down by the OECD across the themes of coherence, economic substance and transparency.

The concept of value chain analysis, though well-known, has gained more significance with the BEPS initiative. From a transfer pricing perspective, the important areas of change lie within the ‘economic substance’ and ‘transparency’ themes. The need for value chain analysis is rooted under both the said themes and is the heart of the BEPS from a transfer pricing perspective.

The OECD3 recognised that there is a need to address the issues arising due to mismatch of economic substance in corporate structures, where the income is parked in low tax jurisdictions under legal entities which lack substance, thus leading to erosion of the tax base of the other high tax jurisdictions.

Some of the guidance available emphasising on the relevance of value chain are reproduced below:

– OECD’s publication on ‘Action Plan on Base Erosion and Profit Shifting’ 2013 has highlighted the importance of value chain analysis:
Action 54 – Point (ii) on ‘Restoring the full effects and benefits of international standards’ states that ‘Current rules work in many cases, but they need to be adapted to prevent BEPS that results from the interactions among more than two countries and to fully account for global value chains’.

– BEPS Action Plan 8-10’s final reports, ‘Aligning Transfer Pricing Outcomes with Value Creation’ released in 2015 lays emphasis on value chain in determining the arm’s length price for transactions with related parties. This was also included in the OECD Transfer Pricing Guidelines, 2017 (‘TPG’), in para 1.51 – Functional analysis, which reads as under:
‘… it is important to understand how value is generated by the group as a whole, the interdependencies of the functions performed by the associated enterprises with the rest of the group, and the contribution that the associated enterprises make to that value creation. It will also be relevant to determine the legal rights and obligations of each of the parties in performing their functions…
Determining the economic significance of risk and how risk may affect the pricing of a transaction between associated enterprises is part of the broader functional analysis of how value is created by the MNE group and the activities that allow the MNE group to sustain profits, and the economically relevant characteristics of the transaction…” para 1.73

3   OECD
– Organization for Economic Co-operation and Development

4   Action
5 relates to countering harmful tax practices more effectively, taking into
account transparency and substance

– The TPG lays emphasis on the principle of substance over form in para 1.66 which reads as under –
‘The capability to perform decision-making functions and the actual performance of such decision-making functions relating to a specific risk involve an understanding of the risk based on a relevant analysis of the information required for assessing the foreseeable downside and upside risk outcomes of such decisions and the consequences for the business of the enterprise…’

– The public discussion draft of revised guidance on Profit Splits of 20165, contained a section on value chain analysis, which emphasised the following –
• A value chain analysis can be used as a ‘tool to assist in delineating the controlled transactions, in particular in respect of the functional analysis, and thereby determining the most appropriate transfer pricing methodology.’
• A value chain analysis ‘does not, of itself, indicate that the transactional profit split is the most appropriate method, even where the value chain analysis shows that there are factors which contribute to the creation of value in multiple places, since all parties to a transaction can be expected to make some contributions to value creation’.

However, this section was eliminated from the final Guidance as it was thought that overemphasis could unduly uplift the significance of profit splits even in cases where this would not be the best method.

5   https://www.oecd.org/tax/transfer-pricing/BEPS-discussion-draft-on-the-revised-guidance-on-profit-splits.pdf

– In relation to analysis of intangibles, the TPG lays focus on identifying the factors that contribute to value creation and entities that perform economically significant functions in relation to the intangibles which are used by the MNE to create value for the business. The relevant paras are given below:

‘…In cases involving the use or transfer of intangibles, it is especially important to ground the functional analysis on an understanding of the MNE’s global business and the manner in which intangibles are used by the MNE to add or create value across the entire supply chain…’ para 6.3

‘In a transfer pricing analysis of a matter involving intangibles, it is important to identify the relevant intangibles with specificity. The functional analysis should identify the relevant intangibles at issue, the manner in which they contribute to the creation of value in the transactions under review, the important functions performed and specific risks assumed in connection with the development, enhancement, maintenance, protection and exploitation of the intangibles and the manner in which they interact with other intangibles, with tangible assets and with business operations to create value…’ para 6.12.

– BEPS Action Plan 13 on three-tier documentation requires disclosure of certain information in the master file for the MNE group such as key value drivers of
the business, details on intangibles, transfer pricing policies, contribution of the key group entities, etc., which will enable tax administrations access to global documentation leading to enhanced transparency
and thereby provide a mechanism to tackle BEPS problems.

– Both the local documentation and the CbCR could reveal the key data points in relation to the MNCs’ IP activities highlighting the low substance entities generating lower taxable income.

– Also, there are certain countries (such as China, Germany, Spain, Austria, Ecuador, South Africa, etc.) where the tax administrations lay emphasis on documentation of the VCA in the local TP documentation.

WHAT IS VALUE CHAIN ANALYSIS (‘VCA’)
VCA can be said to be a blueprint of the MNE’s group operations. The analysis involves a detailed investigation into the functions, assets and risks of the MNE as a whole and thereby evaluating the contribution of each of the activities involved in the value chain to the overall value created by the group. A VCA is a deep-dive analysis of understanding where and how the economic value is created and by which parties within a multinational group.

A VCA reflects the key value drivers for an MNE’s business, sector, or line of activity and identifies the relative contributions to the value-creation process. Value driver is something that contributes to the generation of income for an MNE’s business. Value drivers could also be defined as the performance variables that will actually create the value of the business.

The value drivers may vary across different businesses, industries and sectors. It is important to note that the nature of the business or industry generally defines whether it has more of tangible or intangible value. Most of the service industry players will have greater intangible value while an asset intensive industry will have higher tangible value. For instance:
(a) For Apple, which is one of the leading companies which sells computers, mobile phones and such other electronic devices, their key value drivers would be continuous innovation, unique technology which differentiates their products from the other competitors in the market, brand, customer loyalty, geographic reach, etc.
(b) For an IT company like Infosys which is a multinational company engaged in providing services in the area of information technology, business consultancy, outsourcing and managed services, their key value drivers would be employee productivity, a skilled and trained workforce, a global delivery model, latest technology, acquisitions, etc.
(c) For a company like McDonalds which falls under the fast-food industry, the value drivers would be product quality and customer health, human capital, environment footprint, brand management, sustainable supply chain and packaging waste, etc.
(d) For a company like Paytm which is a leading digital financial services platform, the value drivers would be technology, customer experience, availability of frictionless payment options, etc.

The VCA highlights the economically significant functions performed and risks assumed by the MNE group and also by the individual entities within the group which leads to value creation for the group. Further, by understanding whether an entity is really controlling the function / risk, it becomes easier to understand whether such an entity is adequately remunerated for these activities in line with its value contribution and whether it would need to be remunerated if there is a transfer of such function or risk from that entity to any other group entity. The VCA helps in identifying the commercial or financial relations between the parties and thereby assists in accurately delineating the controlled transactions based on the actual conduct of the parties in the entire value chain. A VCA is therefore a critical and important step for the purpose of drawing conclusions from a tax and transfer pricing perspective to align the value drivers with the functions performed and risks borne by the respective entities in the global value chain.

STEPS FOR UNDERTAKING VCA
There is no ‘right’ way of conducting a value chain analysis because every business will have its own value drivers and value creation story. Further, there are various techniques that can be applied while conducting a VCA to map the activities against the value creation. We explain below some of the steps which need to be considered in performing a VCA:

Step 1: Identification of the value drivers for the business
Value drivers in principle are common for a business operating in a particular industry or sector; however, its importance will vary from business to business. These drivers can be linked to the tangible assets or intangible assets of the business that are created or used for conducting the business, the various processes / systems adopted, customer relationships developed, the skilled workforce, or even the culture of the organisation which leads to value creation. Also, not all the value drivers would draw equal weightage when their contributions in the value chain are analysed. Hence, it is important to evaluate their relative value in the entire value chain by assigning a numerical weightage to them.

Step 2: Mapping the contribution by the legal entities / territories
The next step is to determine and map the contribution to the value generated by the value drivers with the legal entities that are part of the value chain. This will involve conducting a detailed functions, asset and risk analysis for the legal entities, analysing the key tangible and intangible assets employed and the risks assumed by the entities while contributing to the value chain. The OECD guidelines provide a detailed framework on risk analysis – control and management of risks, which would play a vital role in determining their weightage in value creation. Para D.1.2.1.1 of the TPG.

Step 3: Allocate the profits to the legal entities
Based on the results of Steps 1 and 2, the overall profit of the group is calculated and then appropriately allocated to the respective legal entities in line with the weightage assigned to the relative contributions of the entities in the value chain.

Step 4: Alignment with the transfer pricing outcomes
The results of Step 3 can be compared with the existing or proposed transfer pricing for controlled transactions across the group and in alignment with the value created by each of the entities in the value chain. VCA is a corroborative analysis which would help identify the mismatches in the pricing for the individual entities by providing a holistic picture of the allocation of profit results at a group level.

We have illustrated below a case study evaluating the value chain for an MNE group:

In relation to the above case study:
• F Co. is the parent company of I Co., S Co. and D Co.
• F Co. is engaged in full-fledged manufacturing activities.
• I Co. and S. Co. are R&D centres of the group.
• I Co. supervises the R&D services performed by S Co.
• D Co. is a full-fledged distributor engaged in distribution of goods in the local jurisdiction.

Value chain – Analysis of the value contribution of each of the parties

In order to perform an analysis of the value contribution of each of the entities it is essential to understand the functions performed and risks assumed by each of the entities in the value chain. From the above tabulation of the functional and risk analysis of all the entities participating in the value chain of the group, it is evident that the primary functions in the value chain are research and development, procurement, manufacturing, sales and marketing and after sales services. Various entities of the group based in different geographies are engaged in performing the said activities in relation to these functions which leads to creation of value for the group and thereby results in generating profits. The key value drivers for this business are people, technology, marketing intangible (brand), customer base, innovation through R&D, location savings, etc.

In the above case study, from a transfer pricing perspective the following are the key points for consideration:
a) F Co. being the IP owner contractually assumes the financial risk and has the financial capacity to assume the risk in relation to the IP developed as a result of the R&D activities performed by I Co. and S Co. However, it does not exercise any control over these risks. Accordingly, in addition to the return on the manufacturing function, F Co. may only be entitled to a risk-free return on the funding activities.
b) I Co. is entitled to returns derived from the exploitation of the intangibles developed as a result of the R&D efforts of I Co. and S. Co., as it performs both the development and risk management functions in relation to the intangibles developed.
c) S Co. needs to be remunerated for its contract R&D services rendered to F Co. based on the function, asset and risk analysis in relation to these activities performed by F Co. In determining the remuneration for S Co., it will be critical to consider the comparability factors such as the skill sets of the employees employed for performing the R&D services, the nature of research being undertaken, etc.
d) D Co. is a full-fledged distributor and needs to be remunerated adequately for the distribution functions performed by it.

In the above case study, based on the steps for conducting the VCA (explained before the case study), the controlled transactions were accurately delineated from the value chain and the key functions performed and risks assumed by the respective group entities in the value chain have been identified and evaluated. On the basis of the evaluation of the contribution of each of the parties, the remuneration in line with the conduct has been discussed in the above section.

In practical scenarios, the value chain analysis could be more complex for large MNEs where the supply chain is fragmented across various geographies with multiple group entities involved in the value chain performing various integrated functions. Accordingly, it is necessary to follow a methodical and step-by-step process while conducting the value chain analysis which forms the basis of tax and transfer pricing analysis for the group at a global level.

Purpose of conducting a value chain analysis in the current environment
a) Supply chain analysis vis-à-vis traditional FAR analysis vis-à-vis value chain analysis
A value chain as a concept is different from a supply chain. A supply chain typically focuses on the ‘flow of goods and services’, while value chain addresses the question of what value the business has created by analysing what it is able to sell in the market and what is the cost of creating that.

Supply chain can be described as a business transformation tool which helps in minimising the costs, maximising the customer satisfaction by ensuring that the products are provided to the customers at the right time and place; whereas value chain provides the competitive advantage which ensures that the competition is taken care of by fulfilling customer satisfaction by adding value. Supply chain is only a component of the value chain.

The value chain analysis supplements the traditional functional analysis and establishes the connection on how the FAR and value drivers contribute value to the MNC. The value chain analysis strengthens the documentation as it evaluates both sides of the contracting parties and provides a justification of the arm’s length principle by highlighting the alignment of the transfer pricing policy with the actual conduct of the parties. The robust documentation will serve as back-up to defend the pricing policy during transfer pricing audits. This will also be relevant during negotiations with the APA / competent authority on the allocation of profits among the parties in the value chain as the documentation clearly highlights the robust functional profile.

b) Globalisation and decentralisation of functions, digitalisation
With the emergence of MNEs across different jurisdictions, the competitiveness of the companies is influenced by the efficiency of the supply chain and the corresponding value created by each of the functions in the value chain. Given the current dynamics, not only the supply chain but also the value chain is shifting towards becoming more sustainable, globalised and digitalised.

Digitalisation is bringing about a change by introducing new operating models and revolutionising the existing models. With this there is bound to be a change in the value drivers of the companies and a shift in the functional profile. Corresponding alignment of the pricing policy with the value creation / contribution of each entity in the value chain is going to be critical in order to ensure appropriate allocation of the profits to the entities.

6   In
transfer pricing cases involving intangibles, the determination of the entity
or entities within an MNE group which are ultimately entitled to share in the
returns derived by the group from exploiting intangibles is crucial. A related
issue is which entity or entities within the group should ultimately bear the
costs, investments and other burdens associated with the Development of
intangible asset, Enhancement of the value of intangible asset, Maintenance
of intangible asset, Protection of intangible asset against infringement
and Exploitation of intangibles

c) Assessing the value in the value chain for intangibles
For the purpose of assessing the value, the strong focus is on DEMPE function6. It is important that the profit allocation is based on the functional substance-based contribution towards the DEMPE of the intangibles. The value drivers in the case of intangibles go beyond the legal definition of the intangible. In the case of intangibles, factors such as risks borne, specific market characteristics, location, business strategies and group synergies could contribute to value creation. All the entities performing functions, using assets or assuming risks for contributing to the value of the intangible, must be adequately remunerated for their contribution under the arm’s length principle.

d) Application of profit split method (PSM) for value chain analysis
The main objective of BEPS is that the transfer pricing outcomes are in sync with the economic value created. Hence, it becomes necessary to accurately delineate the actual transaction and its pricing in accordance with the most appropriate method selected to justify the arm’s length principle. The transfer pricing regulations requires selection of the most appropriate method to justify the arm’s length principle. PSM7 could be considered as the most appropriate method as it advocates alignment of profits with the relative values / contribution of the functions, assets and risks.

7   PSM
– is applied in cases involving transfer of unique intangibles or highly
integrated operations that cannot be evaluated on an individual basis, i.e.,
they are intrinsically linked

The Covid-19 pandemic has hit the international trade hard thereby causing concerns of serious disruptions to the global value chains (GVCs). The pandemic has impacted the way companies conduct their operations – consequential changes to the value chains as a stop-gap arrangement or a permanent modification to how the business was undertaken.

Some of the instances of disruption in the value chain are given below:
(a) Lockdowns changed the dynamics of how products were sourced. There was a sudden shift from brick-and-mortar retail chains to digital marketplaces / e-commerce platforms. Unlike historically where the physical stores, sales personnel, advertising, etc., which were value drivers in the value chain, now the value contribution of digital / ecommerce platforms has increased significantly.
(b) MNCs having centralised sourcing for their manufacturing / trading activities, faced challenges due to supply chain disruptions. Many resorted to decentralised sourcing from alternate locations / suppliers.
(c) The pandemic influenced work from home for employees which disrupted the provision of services. Example – employees responsible for performing significant DEMPE functions had to work from remote locations thereby disrupting the significance of the location base.

Both the business operations and the financial markets got disrupted due to the pandemic. For the companies that reorganised their operations to adapt to the evolving economic and business environment, the existing transfer pricing policies may no longer apply in line with the transformation of the value chain. In order to sustain their business operations, some companies moved parts of their supply chains as a result of the pandemic, thereby making existing transfer pricing policies obsolete. Due to the impact on the profitability or disruptions to cash flows, the existing transfer pricing policies may not be complied with due to the inability to compensate the entities in line with the functions they performed. Hence, it would be critical for taxpayers to evaluate whether changes in a value chain result in transfer of value or alteration of the profit potential of group entities in their jurisdiction. Thus, taxpayers need to be alert about such eventualities.

Since the pandemic has impacted the economic conditions significantly, this would have an effect on the APAs entered into covering the pandemic year onwards. Most APAs include specific assumptions about the operational and economic conditions that will affect transactions covered in the APA. Hence, it is critical to determine to what extent the changes will affect the application of existing APAs. Since the pandemic has not affected all companies equally, the individual cases of each taxpayer should be evaluated.

JUDICIAL PRECEDENCE – INDIAN AND GLOBAL
With the above detailed discussion on the concept of value chain and the need for conducting the same, let us look at how value chain analysis has gained significance from the Indian perspective. The transfer pricing provisions in India were enacted in the Income-tax Act in 2001 and since then the transfer pricing law in India has evolved with substantial developments. Though the Indian provisions do not provide detailed guidance on various transfer pricing issues, the Indian tax authorities including the dispute resolution forums and Tax Courts place reliance on international guidelines such as the OECD TP guidelines, the United Nations’ TP Manual and guidelines published by various countries while conducting TP audits and deciding on the complex issues related to transfer pricing.

India has also adopted the BEPS Action Plan 13 – three-tier documentation (country-by-country report, master file and local file) in the local regulations in 2016 with additional requirements for master file compliance, wherein it requires the MNC’s to provide the drivers of profits for the business, the transfer pricing policies and strategies in relation to intangibles and R&D facilities and the detailed functional analysis for principal entities contributing to the profits, revenue or assets of the group as per the specified threshold. Pursuant to the BEPS Action Plans released in 2015, the concept of substance over form, i.e., actual conduct of the parties vis-à-vis the legal form plays a vital role in determination of the arm’s length price for a controlled transaction. The Indian tax authorities during the course of TP investigations attempt to re-characterise the transaction to determine the arm’s length price based on the actual conduct of the parties rather than the contractual arrangements, which is in line with OECD guidelines.

Some of these case laws where emphasis is laid on the value chain analysis are summarised below:
a) In the case of L’Oreal India Pvt. Ltd. [TS-829-ITAT-2019 (Mum)-TP], the Mumbai Income Tax Appellate Tribunal (ITAT) referred to the Development Enhancement Maintenance Protection and Exploitation (DEMPE) framework while analysing the issue of marketing intangibles arising due to the significant incurrence of Advertising, Marketing and Promotion (AMP) expenses. The ITAT held as follows:
• the sine qua non for commencing the TP exercise is to show the existence of an international transaction and the same had not been shown to have been fulfilled in the instant case, therefore, the issue of traversing to the aspect of determining the validity of the method for determining the ALP of such transaction does not arise at all.
• The assessee had never admitted that the incurring of AMP expenses was an international transaction and had, in fact, since inception canvassed that the said expenses were incurred in the normal course of its own business and not for rendering any DEMPE functions for brand building of its AE.
• Accordingly, the ITAT held that no part of the AMP expenses incurred by the assessee are attributable to rendering of any DEMPE functions for the brands owned by the AE and deleted the adjustment proposed by the Indian Revenue Authorities with respect to the AMP expenses incurred by the assessee.
• The ITAT distinguished the decision of the High Court in the case of Sony Ericsson India Pvt. Ltd. by recording the finding that the presence of AMP as a transaction was accepted by the assessee itself in case of the High Court decision, whereas in the current case the assessee had never made any such admissions.
• The ITAT further remarked that de hors any ‘understanding’ or an ‘arrangement’ or ‘action in concert’, as per which the assessee had agreed for incurring of AMP expenses for brand building of its AE, the provisions of Chapter X could not have been invoked for undertaking a TP adjustment exercise.

From the above case it is evident that the ITAT has laid emphasis on evaluation of the DEMPE functions performed by the entities in the group for determining whether incurring of AMP expenses alone leads to brand-building for the AE for which the assessee needs to be remunerated separately as an international transaction. Accordingly, a detailed value chain analysis for an MNE group which also includes analysis of the DEMPE functions in relation to the intangibles would help in strongly defending its position before the tax authorities.

b) In the case of Infogain India Pvt. Ltd. [TS-392-ITAT-2015 (Del)-TP], the Delhi ITAT upheld the application of the Profit Split Method (PSM) adopted by the assessee on the ground that the activities of the assessee and its associated enterprise were intrinsically linked and both the entities were significantly contributing to the value chain of provision of software services to the end customers. The ITAT, based on the examination of the functions performed by both the parties and weights assigned to each activity, observed that – ‘In the present case, both the parties, i.e., Infogain India (assessee) and Infogain US are making contribution. Therefore, the Profit Split Method is the most appropriate method for determination of ALP.’

c) In the Coca-Cola USA case8, the US Tax Court confirmed an adjustment made by the Internal Revenue Service (‘IRS’) to the income of the company. The issue under examination was that Coca Cola was not adequately compensated (i.e., with royalty) by its group entities for the use of intangibles. While deciding this issue, the IRS laid emphasis on the functions performed by the respective entities in the supply chain, risks control and allocation, DEMPE functions in relation to the intangibles, costs incurred by the different entities on the Advertising, Marketing and Promotion expenses, and contractual arrangements between the group entities. Upon in-depth analysis, the IRS proposed to benchmark the transaction in question using the Comparable Profits Method (CPM) treating unrelated bottlers as comparable parties wherein ‘Return on Assets’ (ROA) was taken as the appropriate Profit Level Indicator. The US Tax Court upheld the contentions of the IRS based on the above economic analysis conducted to derive an approximate royalty payment to Coca Cola Company by the group entities.

8   155
T.C. 10 Docket No. 31183-15, US Tax Court, Coca Cola Company & Subsidiaries
vs. Commissioner of Internal Revenue

d) In the case of Dutch taxpayer Zinc Smelters BV9, the taxpayer was engaged in the business of zinc smelting. The zinc smelting process involved conversion of zinc ore and the related raw materials into pure zinc and the same was distributed in the market. The value chain of this activity comprised of key functions, namely, procurement of raw materials, planning and scheduling of production, undertaking the production activity, planning the logistics and distribution in the market, undertaking support functions such as finance, IT, marketing, etc. Globally, the business of the group was sold, pursuant to which all the functions except the production activity were transferred to a new entity. The question was regarding the remuneration of the taxpayer post the business restructuring. The Dutch Court of Appeals agreed with the ruling of the Dutch tax authority that the key functions of sourcing raw material and thereby conversion of the ore (raw material) into finished product were critical functions in the value chain and were inter-linked. Accordingly, both the taxpayer and the new entity were performing non-routine functions. Hence, profit split was considered as the most appropriate method to determine the arm’s length remuneration for both the entities. For the purpose of profit split, the profit achieved from joint smelting activities of the taxpayer and the new entity were to be determined and then split between both the entities based on their contributions to the revenue generated.

9   Case
number ECLI:NL:GHSHE:2020:968  – 17/00714
Zinc Smelter B.V. vs. Dutch Tax Authority

Some of the instances of business restructuring or reorganisation are as follows:
(a) Reallocation of functions, assets and risks within the group.
(b) Transfer of valuable intangibles within the group.
(c) Termination or renegotiation of the existing contractual arrangements.
(d) Shift of responsibility of specific functions from one entity to another entity within the group.

The taxpayers must maintain robust documentation such as agreements, valuation reports (if any), post-restructuring FAR analysis, etc., to substantiate the arm’s length principle. In the changing dynamics of business, it is imperative that taxpayers monitor business operations more closely for any changes.

DOCUMENTATION
As we all know, documentation forms the core of the entire transfer pricing analysis; accordingly, in a post-BEPS world it is even more critical to ensure that the MNE group has adequately documented its transfer pricing policies which are in line with the value contributions by the respective group entities in the value chain, economic functions performed and risks assumed while dealing with controlled transactions.

In order to manage the risks, the MNCs will have to ensure that the documentation is more elaborate and thorough both in the factual description of the functional profile in the value chain and in the related transfer pricing analysis. A well-documented VCA would serve as a foundation for the MNE’s tax and transfer pricing analysis and help achieve consistency across various facets of regulatory compliances.

Some of the key back-up documentation that can be maintained by an MNE group to support the VCA analysis are listed below:
a. Industry reports, management discussions, financial reports – sources to ascertain the key value drivers for business;
b. Functional interview notes / recordings with key business personnel at management level, operational division personnel, process flowcharts, asset evaluation records, organisation structure, responsibility matrix, etc. – to support the functional analysis documented as part of the VCA;
c. Contractual arrangements within the group entities which are in line with the actual conduct and substance of the parties to the arrangements;
d. Back-up documents to justify the rationale adopted by the management in assigning specific weightages to the value drivers in the value chain while determining the value contribution of the respective group entities;
e. Risk analysis assessment in light of the framework of the guidelines provided by OECD for the group entities – documents which demonstrate key decisions made by entities such as board approvals, internal email correspondences, important call minutes, etc.;
f. Documents which support the legal ownership of intangibles with the group entities such as IP registrations in certain jurisdictions, accounting of these assets in the financial reporting as per local requirements, etc.;
g. Documentary evidences to support the DEMPE functions and the value contribution of each of the entities in the value chain;
h. Analysis of the key financial ratios for the group entities such as costs incurred in production, gross level margins, net profit margins, FTE count, net worth, etc.

The above list is illustrative considering that each business would have a different value chain story and hence one would need to maintain robust back-up documentation to support its VCA for the entire MNE group.

10 Form
No. 3CEB is a report from an accountant to be furnished under section 92E
relating to international transactions and specified domestic transactions

11           Explanation
to Section 92B of the Income-Tax Act 1961, clarifies the expression
‘international transaction’ to include – ‘….. (e) a transaction of business
restructuring or reorganisation, entered into by an enterprise with an
associated enterprise, irrespective of the fact that it has bearing on the
profit, income, losses or assets of such enterprise at the time of the
transaction or at any future date’

The BEPS project has changed the dynamics of the international tax landscape in an unprecedented manner. The advanced work on addressing the tax challenges arising from the digitalisation of the economy will further change the status quo. Both globalisation and trade frictions in certain countries coupled with the severe impact of the Covid-19 pandemic have forced the MNEs to evaluate their global operations and the value chain distribution. This will create even more challenges in the transfer pricing areas which will have to be dealt with by both the MNEs and the tax administrations of the developing countries. It would be critical for the MNEs to effectively focus on their value chain to achieve the desired business and tax objectives in order to sustain themselves in this evolving business environment.