Tax Implications of International Secondment Employees

Just as the ambiguity over tax implications on

secondment of expats to India appeared to be settling down, the Authority for Advance Rulings (‘AAR’) has vide its ruling in the case of Verizon Data Services¹, reopened the Pandora’s box by holding that salary reimbursement of seconded employees is taxable in India as Fees for Included Services (‘FIS’)/ Fees for Technical Services (‘FTS’).

This article discusses key tax implications arising on

Secondment of employees of Foreign Company to Indian Company, in light of the existing regulations and various judicial precedents.

Introduction

Increasing number of MNCs establishing business in India has led to a huge surge in the number of ‘Expatriates’ working in India. The term ‘expatriate’ has not been defined in the Act. However, as

per various legal dictionaries², expatriate means someone who is removed from/voluntarily leaves one’s own country to reside in or become a citizen of another country.

Typically, Foreign Companies (‘FCo’) depute their employees to India either in connection with some project or for rendering services to the Indian company (‘ICo’) or to safeguard their interest in India (stewardship functions). For this purpose FCo may enter into a contract to depute their

employees to ICo for a predetermined time period. FCos also depute their employees to India as a part of a Foreign Collaboration Agreement (‘FCA’) under which they are obliged to provide complete support to ICo in carrying out business ventures.

‘

Deputation’, in common parlance means appointment, assignment to an office, function. The dictionary meaning of the term ‘Second’ is to transfer temporarily to another unit or employment for a special task³. However, as a common practice, both these terms are used interchangeably.

Dual employment

To retain employment with FCo and safeguard the social security/retirement benefits in their home country, expats desire to continue to be on the payroll of FCo and receive salary in their home country. Accordingly, the foreign entity will be regarded as the ‘Legal Employer’. On the other hand, the expats function under the control and supervision of the ICo which eventually bears their salary costs by reimbursing the same to FCo. Thus, ICo can be regarded as the ‘Real’ or ‘Economic employer’.

The concept of ‘Dual Employment’ is also recognised in section 192(2) of the Income-tax Act, 1961 (‘Act’). The Section provides for withholding tax compliances in case of ‘Simultaneous employment’ or ‘Successive employment’ with an option to the employee to choose one of the employers who can consolidate the withholding tax obligations in respect of his salary.

With this background, let us understand the tax implications arising out of the said arrangements.

Key tax implications on secondments

• Expats — Salary received by expatriate employees could be subject to tax in India as such
• Foreign Companies — FCo deputing expats could be subject to tax in India.

For the purposes of this article, we have only discussed the taxability of FCos in India.

Tax implications in the hands of FCo

Taxation of payments made to FCos in India, pursuant to secondment contracts has been a subject-matter of litigation since quite some time now. The Indian

Revenue authorities have been contending that by sending their employees to India, the foreign entities are actually rendering services to the ICo or carrying out business in India. Accordingly, they hold that;

• the payments made by Indian entities are in the nature of Fees for Technical Services (‘FTS’);

or

• the foreign entities have a Permanent Establishment (‘PE’) in India by virtue of the employees’ presence in India.

Consequently, ICo is held liable to withhold taxes u/s.195 of the Act, before making payments to

FCo.

On the other hand, FCos believe that merely by seconding their employees to work under the supervision and control of ICo, they are not rendering any services in India. The amount recharged to ICo

is mere recovery of salary costs of secondee paid by FCo in the home country and no taxable income arises in India.

Explanation 2 to section 9(1)(vii) and Article 12/13 dealing with FTS in many DTAAs specifically excludes ‘salaries’ from the scope of FTS. Thus, if it can be established that the secondee is the employee of ICo, then the salary cost recharged by FCo cannot

be regarded as FTS.

As regards PE, by virtue of its employees’ presence in India, FCos are exposed to two types of PEs; (i) Service PE and (ii) Fixed Place PE. One of the most important factors to mitigate the PE risk in case of secondment arrangements is establishing the fact that the ICo is the real employer of the expats and FCo does not have any presence in India through them.

Thus, the moot question is whether the secondee, who renders services to ICo can be regarded as its employee, even though he continues to remain on the payroll of FCo.

Contract of service and contract for service

A contract, by virtue of which an employer-employee relationship is established, is regarded as a Contract of Service, whereas contracts which entail services to be rendered by one entity to another could be regarded as Contracts for Services. The importance of this distinction is also recognised by the OECD

⁴ in their ‘Model Tax Convention on Income and on Capital’ published in July 2010 (‘hereinafter referred to as the OECD commentary’).

In order to draw distinction between ‘contract of service’ and ‘contract for service’, one needs to understand what constitutes an employment relationship in case of such contracts. Thus, interpretation of the term ‘employer’ assumes paramount significance.

Employer

The term ‘employer’ is not defined in the OECD model convention or in the Indian domestic law. However, the Hon’ble Supreme Court of India, in various

decisions⁵ has laid down the following key tests to determine the existence of employment relationship.

• Control and supervision over the method of doing work;
• Payment of wages or other remunerations;
• Power of selection of the employee;
• Right of suspension or dismissal of the employee

Further, the OECD Commentary

⁶ has also laid down the following key factors for determining an employer-employee relationship:

• Authority to instruct the individual regarding the manner in which the work is to be performed
• Control and responsibility for the place of work
• Remuneration of the individual is directly charged by the formal employer to the enterprise to which the services are provided
• Provision of tools and materials to employee
• Determination of the number and qualifications of the individual seconded
• Right to select the individual to perform work and to terminate contractual agreements with the employee for that purpose
• Right to impose disciplinary sanctions related to the work of that individual
• Determination of holidays and work schedule.

The OECD commentary

⁷ also provides that the financial arrangement between the two enterprises would also be one of the relevant factors in determining the nature of the relationship. Renowned author, Professor Klaus Vogel in his treatise on Double Taxation Conventions has provided his views on the term ‘employer’ as follows

“An employer is someone to whom

an employee is committed to supply his capacity to work and under whose directions the latter engages in his activities and whose instructions he is bound to obey.”⁸

As per Prof. Vogel’s hypothesis

⁹, the determination of employer rests with the degree of personal and economic dependence of the employee towards the enterprises involved. Thus, if the employee works exclusively for the ICo and was released for the period in question by the FCo, he may be regarded as an employee of the ICo.

Thus, the aforesaid criteria can be applied in determining the existence of an employer-employee relationship between the ICo and the Secondee.

Judicial precedents

Having discussed what constitutes an employer - employee relationship, let us now look at the stand adopted by Indian judicial authorities in case of such secondment contracts. The common issue before the judiciary is whether the reimbursement of salary

cost by ICo to FCo could be regarded as income of the FCo (FTS or otherwise) and be subject to withholding tax u/s.195 of the Act?

Having regard to the terms of the secondment contracts and after applying the tests discussed above, the Indian judicial authorities, in various

cases¹⁰ have held that reimbursement of salary costs of seconded employees cannot be regarded as income of the FCo. Consequently, there is no withholding tax requirement u/s.195 of the Act. Some of the key common observations in most of these decisions are discussed below:

• Expats are deputed to work under the control and supervision of the ICo. FCo is not responsible for the actions of the expats. Thus, FCo does not render any technical service to the ICo.
• Since payment by ICo is towards reimbursement of salary cost borne by FCo, no income can be said to accrue to FCo in India.
• Referring to Klaus Vogel’s commentary and the relevant facts, ICo could be regarded as an ‘economic employer’ of the secondees. Agreement constituted an independent contract of service.
• Since the deputed employees were not subject to the control and supervision of the FCo, there would be no Service PE.

However, in case of AT&S India Pvt. Ltd.

¹¹, it was held that compensation paid by ICo to FCo constituted FTS liable to withholding tax u/s.195 of the Act. While arriving at the said ruling, the AAR made the following key observations:

• FCo was the real employer of the secondees as it retains right over the employees and has power to remove/replace them
• Pursuant to foreign collaboration agreement, FCo had undertaken to render the services to ICo and hence, lent the services of its seconded employees on payment of compensation by ICo
• The recipient of the compensation was FCo and not the seconded employees. Further, the payment was not merely reimbursement of salary, it also included other costs
• Thus, compensation referred to in the secondment agreement was for rendering ‘services of technical or other personnel’ —hence taxable as FTS and liable to withholding of tax u/s.195.

Here the key fact noted by the AAR was that the secondment agreement was in connection with the foreign collaboration agreement, whereby FCO had undertaken to render services to ICo. Accordingly, payments made pursuant to the secondment agreement were held taxable in the nature of fees for services rendered by FCo.

Verizon ruling

This recent AAR ruling has reignited the somewhat

settled position as regards secondment contracts.

Facts

The applicant, Verizon India (‘VI’) is engaged in providing software and allied services to its parent, Verizon US (‘VUS’). GTE Overseas Corporation (‘GTE’), another US-based affiliate is engaged in business activity similar to VI. VI entered into an agreement with GTE for secondment of its three employees to India. The structure of the arrangement is depicted below:

One of the secondees assumed the position of managing director of VI while the other two employees liaised between VI and VUS, and

supervised its day-to-day operations. The salient features of the agreement were:

• Employees would function exclusively under the control and supervision of VI;
• Employees would continue to remain on the payroll of GTE;
• GTE would be absolved from the responsibility/ liability of the work, actions performed and the quality of results produced by its employees;
• GTE had the authority to replace and terminate the employees;
• GTE would disburse the salary of the secondees and get the same reimbursed from VI without any mark-up;
• VI would be liable for the Indian withholding tax compliances and the payments to GTE would be made ‘Net of taxes’.

Key questions before the Authority

• Whether the amounts reimbursed to GTE would constitute income accruing to GTE and therefore the same is liable to deduction of tax in accordance with the provisions of section 195 of the Act?
• If yes, then whether the payment is taxable as Fees for Included Services (‘FIS’) under the Act read with the India-USA DTAA?

AAR Ruling¹²

The AAR held that the seconded employees are employees of GTE and not VI. The payments made for performing managerial services would be regarded as FIS under the India-USA DTAA. Also,

managerial services are directly covered under FTS as defined under Explanation 2 to section 9(1)(vii) of the Act. Hence, the payment is taxable and VI would be liable to withhold tax u/s.195 of the Act. While arriving at the said conclusion, the AAR made the following key observations:

• Since the control and supervision of the company vests with the managing director, GTE has rendered managerial services to the applicant.
• The ‘net of tax’ payment clause in the agreement suggests that the services provided by GTE were liable to tax in India.
• Since the employees continue to be on the payroll of GTE, get their salaries from it and can be terminated only by GTE, GTE is the employer of the seconded employees.
• The nature of the two receipts, one in the hands of GTE and the other in the hands of employees by way of salaries spring from different sources and are of different character and represent different species of income.
• As per MOU of the DTAA it is clear that ‘make available’ clause would be applicable only to technical services. ‘Make available’ clause does not apply to managerial services, the payments for which are otherwise covered within the ambit of FIS under Article 12(4) of the DTAA.
• Since the amount reimbursed by the applicant is taxable as FIS, the question of PE is merely of an academic interest. Accordingly, the same was not delved into.

Arguments

Applicant’s (‘VI’s) Submissions	Tax Department’s Arguments
Personnel were deputed at the request of the applicant to work under its control	In substance, seconded personnel represented VUS. GTE is not benefitted in any way by the secondment agreement.
GTE does not render any service to it and the reimbursements of salary without mark-up	Terms of payment included salary, commission, benefits and other items as per international policy and not merely for salary.
Applicant is the economic employer	GTE is the employer since it had unconditional authority to replace/terminate employees. Merely withholding tax u/s.192 would not make applicant an employer. Relied on Morgan Stanley 13, which held that employees of the deputing company do not become the deputed company.
The same amount cannot be subjected to withholding tax u/s.192 and u/s.195	Relying on the decision in the case of AT&S, it was contended that reimbursement is in the nature of FTS and the fact that taxes are paid under the head ‘Salaries’ is of no consequence.
Under Article 12(4)(b) of the DTAA, Fees for Included Services (‘FIS’) clause is not applicable since the services being rendered are managerial and not technical, hence, ‘make available’ condition cannot be satisfied	Services rendered by the secondees are technical in nature and would be covered under Article (12)(4) of the DTAA.
No fixed place from where GTE is carrying on business in India. Even if it has a fixed place of business, the employee cost would be deductible as an expense from the income earned by it. The net income would be nil and there will be no requirement to withhold tax.

Analysis

• AAR has not appreciated that managing director is subject to the superintendence and control of Board of Directors and MOA/AOA of the company. The fact that a managing director can be regarded as an employee of the company has been discussed in several judicial precedents¹⁴. The AAR also failed to consider the Tribunal rulings in the cases of IDS Software and Karlstorz Endoscopy India, which dealt with similar facts.
• AAR failed to consider Circular No. 720 of the CBDT, dated 30th August 1995, which clarifies that each section relating to tax withholding under Chapter XVII of the Act deals with a particular kind of payment and excludes all other sections in that Chapter and that the payment of any sum shall be liable to deduction of tax only under one section. This Circular was duly relied upon in the case of HCL¹⁵. Withholding tax on reimbursements u/s.195 which have already suffered tax u/s.192 amounts to double taxation.
• While analysing whether the ICo is the real employer, the AAR ignored the key tests laid down by the Supreme Court, OECD guidelines and Klaus Vogel’s commentary on International Hiring Agreements.
• AAR has misinterpreted the FIS clause in the India-US treaty by holding that for services that are technical or consultancy in nature, the make available clause would not apply. Various judicial precedents¹⁶ have held that services which are not technical in nature are not covered within the scope of FIS clause.
• The AAR ruling is also not in line with other decisions pronounced on similar issue by various authorities in the cases of HCL Infosystems, Cholamandalam MS General Insurance, IDS Software Solutions, etc.

Key takeaways

• Since the law is not yet settled and various judicial authorities have adopted different interpretations, drafting of the secondment agreement by clearly defining the nature of relationships between various parties assumes paramount significance.
• While drafting the agreement, the principles promulgated by the OECD and the tests laid down by the Apex Court which determine the existence of an employer-employee relationship should be kept in mind.
• The documentation and conduct of the seconded employees may also influence taxation of such transactions.
• A periodic review of the documentation and compliance process in line with the latest judicial precedents could help in mitigating risk.

Conclusion

The conflicting rulings by various authorities and the uncertainty on taxability of payments made

pursuant to secondment contracts continue to create a dilemma in minds of Indian as well as multinational corporations deputing their employees in India. However, to put at rest the stir created by such rulings, concrete clarification from the Legislature¹⁷ or the final word from the Apex Court in the near future is the need of the hour. Till then it’s a wait-and-watch situation for all¹⁸.

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1. Verizon Data Services India Private Limited v. CIT (AAR No. 865 of 2010)

2. a. L aw Lexicon (2nd Edition, reprint 1999 on page 681) — ‘Renunciation of allegiance, one voluntary renunciation of citizenship in order to become a citizen of another country’

b. Black’s law dictionary (Sixth Edition, page 576) — The voluntary act of abandoning renouncing one’s country and becoming the citizen or subject of another

c. Webster — Residing in a foreign country

d. O xford — Remove onself from homeland

3. A s noted by the AAR

Cholamandalam MS General Insurance Co. (2009 TIOL 02 ARA-IT)

4. Para 8.4 of the Commentary on Article 15

5. Lakshminarayan Ram Gopal (25 ITR 449);

Piyare Lal Adishwar Lal (40 ITR 17); Ram Prashad (86 ITR 122)

6. Para 8.14 of the Commentary on Article 15

Note:

Though India is not an OECD member, the OECD guidelines have been extensively used by the judicial authorities in interpretation of the Double Tax Avoidance Agreements.

7. Para 8.15 of the Commentary on Article 15

8. Page 899

9. Page 885

10. IDS Software Solutions v. ITO, 2009 TII 22 ITAT-Bang-Intl; Cholamandalam MS General Insurance Co. Ltd. (‘CM’) (2009 TIOL 02 ARA-IT) (Advance Rulings);

Tekmark Global Solutions LLC (‘TLLC’) (131 TTJ 173) (Mumbai-ITAT); ACIT v. Karlstorz Endoscopy India Pvt. Ltd. (‘KI’) (ITA No. 2929/Del/2009)

11. AT&S India Pvt. Ltd. — 287 ITR 421 (‘AAR’) — Distinguished in case of Cholamandalam MS General Insurance Co. Ltd.

12. AAR ruling is binding only on the applicant and the Income tax officer in respect of transaction in relation to which the ruling is sought. However, persuasive value may be drawn in other similar cases.

13. DIT v. Morgan Stanley and Co. Inc. 292 ITR 416 (SC)

14. K. R. Kothandaraman v. CIT (1966) 62 ITR 345 (Mad), Scottish Court of Sessions in Anderson v. James Sutherland (1941) S.C. 203, Ram Prashad v. CIT (1972) 86 ITR 122 (SC)

15. In HCL Infosystems Ltd. v. DCIT, (76 TTJ 505, later affirmed by Delhi High Court in 272 ITR 261), Delhi ITAT held that reimbursement of salary cost of personnel seconded by Indian company to foreign company was not subject to tax withholding u/s.195

16. Raymonds Ltd. 80 TTJ 120 (Mum.), Boston Consulting Group – 93 TTJ 293, McKinsey & Co. Inc (Philippines) & others 99 TTJ 857 (Mum.)

17. The Legislature has recognised the ambiguity and has endeavoured to provide some clarity on the subject by defining the term employer in the proposed Direct Taxes Code, 2010.

18. Verizon has filed an appeal before the High Court against the said ruling. The outcome is eagerly awaited.