AAR ruling on taxability of reimbursement of salary costs of seconded employees to group company not based on proper reasoning Madras High Court

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1 Sharing insights News Alert 16 December, 2011 AAR ruling on taxability of reimbursement of salary costs of seconded employees to group company not based on proper reasoning Madras High Court In brief In a recent direction on the writ petition by Verizon Data Services India Pvt. Ltd. (VDSL) 1, the Madras High Court has set aside the Ruling of the Authority for Advance Rulings (AAR) and remanded to AAR for re-examining the issue relating to the taxability of reimbursement of salary costs to group company pertaining to seconded employees as per the Double Taxation Avoidance Agreement between India and the USA (tax treaty). 1 Verizon Data Services India Pvt. Ltd. v. AAR [ TS-725-HC-2011(MAD)] Facts VDSL is engaged in providing services relating to development and maintenance of telecom software solutions and information technology enabled services to Verizon Data Services LLC, US (Verizon US). In order to meet the business requirement of VDSL, three employees of GTE Overseas Corporation, USA (GTE US), an affiliate company of Verizon US, were seconded to VDSL. In relation to this, a secondment agreement was entered into between VDSL and GTE US. 1

2 As per the secondment agreement, each employee functioned and acted exclusively under the direction, control and supervision of VDSL. GTE US was not responsible for the work of any employee and did not undertake any obligation or risk in relation to the quality of the results produced from the work performed by these employees. GTE US would remunerate the employees and in turn VDSL would reimburse GTE US for the same. In relation to the secondment agreement, VDSL sought a Ruling from the AAR to determine whether the reimbursement of the salary of seconded employees to GTE US would be income subject to withholding tax in India either as fees for technical services or as business profits attributable to a permanent establishment in India under the tax treaty, and if so, to determine the applicable rate of withholding tax. The AAR held the payments to be income for GTE US subject to withholding tax in India as fees for managerial services under Article 12(4)(b) of the tax treaty at the rate of 20%. The AAR further held the payment to be covered by the definition of fees for technical services also, under section 9(1)(vii) of the Act. The AAR overruled the contention of VDSL that the payments constitute costto-cost reimbursement of the salary paid to seconded employees, holding that the receipt by GTE US from VDSL and receipt of salary income by the employees spring from independent sources and cannot be correlated. Aggrieved by the ruling of the AAR, VDSL filed a writ petition under article 226 of the Constitution of India before the High Court of Chennai, challenging the validity of the ruling on the grounds that it is perverse due to lack of appreciation of the facts and issues, and hence should be quashed. Issues 1. Whether the Ruling could be subject to judicial review under the writ jurisdiction of the Court in light of its binding nature under section 245S of the Income-tax Act, 1961 (the Act). 2. Whether the AAR erred in holding that the sums payable by VDSL under the secondment agreement constitute income accruing to GTE US and thus subject to withholding tax under section 195 of the Act. 3. Whether the AAR erred in holding that GTE US provided managerial services falling within the purview of Article 12(4)(b) of the tax treaty, and whether the make available clause under the Memorandum of Understanding of the tax treaty applies only to technical services. 4. Whether the AAR erred in not giving any finding regarding the characterisation of payments as business profits attributable to the permanent establishment of GTE US in India, if any, under the tax treaty. 5. Whether the AAR erred in determining the rate of 20%. Issue 1 The High Court has the jurisdiction to interfere with the ruling and issue direction when it finds the ruling to be perverse and when the AAR failed to properly consider the questions raised in light of the secondment agreement. The writ petition is maintainable due to flaws in the reasoning of the AAR which involves substantial question of law, and also since the findings ignore/overlook vital clauses in the secondment agreement. 2

3 Reliance was placed on the decisions of the Supreme Court in R.Shreeram Durga Prasad and Fatehchand Nursing Das v. Settlement Commission (IT and WT) 2 and in Jyotendrasinhji v. S.I.Tripathi &Ors 3. Revenue s contention Given the fact that the AAR had interpreted the various clauses in the secondment agreement between GTE US and VDSL, the question of the High Court drawing a different conclusion does not arise. VDSL no longer has the opportunity to challenge the Ruling since there is a finality attached to it. Following the decision of the Supreme Court in the Jyotendrasinhji case (above), relied on by VDSL, the High Court upheld the maintainability of the writ petition. In so doing, the High Court reiterated that it is concerned with the legality of the procedure followed and not with the validity of the order. The constitutional right is always available to the party to challenge an apparent error in the ruling given the scope of the judicial review on the grounds of perversity, on the grounds of the ruling going against the provisions of law by not considering various clauses in the secondment agreement. 2 R.Shreeram Durga Prasad and Fatehchand Nursing Das v. Settlement Commission (IT and WT) [1989] 176 ITR 169 (SC) 3 Jyotendrasinhji v. S.I.Tripathi &Ors [1993] 201 ITR 611 (SC) Issue 2 Payments are in the nature of reimbursement of salary and expenses incurred by GTE US in relation to the seconded employees constituting mere cost-tocost reimbursement. VDSL being the economic employer of the seconded employees has reimbursed their salary costs to the GTE US which is the principal employer. This does not mean that the payment made would have the character of income. Reliance was placed on CIT v. Siemens Aktiongesellschaft 4, CIT v. Industrial Engineering Projects Pvt. Ltd 5, Cholamandalam MS General Insurance Co. Ltd 6 to substantiate that reimbursement is not taxable as income. The payment is income in the hands of GTE US and liable to withholding tax under section 195 of the Act. The question whether the receipt is really income or reimbursement is a pure question of fact which has to be determined based on various clauses in the secondment arrangement between VDSL and GTE US. Since the AAR had examined the relevant clauses in the agreement before holding that the receipts are income for GTE US, the High Court cannot substitute its own view for the reasoning of the AAR. 4 CIT v. Siemens Aktiongesellschaft [2009] 310 ITR 320 (Bom-HC) 5 CIT v. Industrial Engineering Projects Pvt. Ltd [1993] 202 ITR 1014 (Del-HC) 6 Cholamandalam MS General Insurance Co. Ltd, In re [2009] 309 ITR 356 3

4 Issue 3 Article 12(4)(b) of the tax treaty deals with technical and consultancy services that make available technical knowledge, experience, skill, know-how etc., and even though on an examination of the facts the AAR found that GTE US rendered managerial services which are not technical in nature, the AAR held that Article 12(4)(b) is attracted, thereby committing a serious error. In view of the patent illegality, the ruling should be quashed. Even though the services of the seconded employees were not technical services, on the basis of the nature of their duties, the services fall under the description of consultancy services as per Article 12(4)(b) of the tax treaty. No exception could be made to hold that the nature of services provided by GTE US are in the nature of managerial services to fit in with the definition of fees for technical services, and thus be governed by Article 12(4)(b) of the tax treaty It is difficult to correlate the findings of the AAR with the conditions set out in Article 12(4)(b) of the tax treaty to characterise the payments as fees for technical services. In the circumstances, this portion of the ruling merits to be set aside, and accordingly the matter is remanded to the AAR for reconsideration of this portion of the Ruling in light of provisions of tax treaty by giving an opportunity to VDSL to be heard. Issue 4 The ruling is not sustainable as it fails to answer the question on the characterisation of the payments as business profits attributable to the permanent establishment of GTE US in India, if any, under the tax treaty. In the light of answers given regarding the taxability and characterisation of payments, the question of the attribution of profits to a permanent establishment is academic. In view of Issue 3 being remanded to the AAR, it is fitting that Issues 4 and 5 also merit fresh consideration by the AAR. Issue 5 When the ruling is on the taxability of the reimbursement as income under the Act as well as under the tax treaty, the rate of tax has to be in accordance with section 90(2) of the Act. Thus GTE US is entitled to the more beneficial rate of 10%. Not available. 4

5 In view of Issue 3 being remanded to the AAR, it is fitting that Issues 4 and 5 also merit fresh consideration by the AAR. In cases where there are employment secondment arrangements in place, requiring the remittance of salary costs overseas by Indian employers, the facts and circumstances of the arrangement require, careful analysis on a case by case basis in order to determine the tax implications. Conclusion The ruling of the AAR, though binding and final, is susceptible to judicial review in the event that the High Court is satisfied that it is perverse or that facts vital to the issue under reference have not been appreciated properly and have been misinterpreted with the law. The High Court s direction in light of conflicting judicial precedents 7 as to whether the reimbursement of salary costs to an overseas company ought to be categorised as fees for technical/included services and be subject to withholding tax, remains an issue for debate. The High Court, while declining to interfere with the Ruling of the AAR that the payments are not reimbursements and constitute income subject to withholding tax under section 195 of the Act, has directed the AAR to re-examine whether they would be characterised as fees for technical services under Article 12(4)(b) of the Tax Treaty. Though the direction is on the basis of specific facts, the issue whether the payments under the employment secondment arrangements requiring remittance of salary costs overseas would be subject to withholding tax still remains open. 7 AT&S India Pvt.Ltd, In re [2006] 287 ITR 421 (AAR), ACIT v. Karlstorz Endoscopy India Pvt Ltd. [2010-TII-135-ITAT- DEL- INTL], IDS Software Solutions India Pvt Ltd. v. ITO (IT) [2009] 122 TTJ 410 (Bang) 5

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