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“Secondment of employees and tax litigation – A perpetual battle" – Part 2

May 25, 2020

Earlier in Part 1 of his article, Dharan V. Gandhi ( Advocate) deliberated on tax implications in respect of payments made by Indian companies to their overseas counterparts for secondment of employees, more particularly employees deputed at senior positions. In Part 2, this week the author discusses the legal jurisprudence rendered by the Indian Courts / Tribunals and extensively evaluates the angle of reimbursement of salary vis-a-vis FTS. 

The author highlights that, reimbursement cannot be considered as income per se and therefore, the same cannot be taxed, irrespective of gross or net basis of taxation and remarks that, “once the payment is mere reimbursement of expenses, there arises no tax implication. The subsequent discussion of FTS and Permanent Establishment (‘PE’) is without prejudice to the argument of reimbursement”. 

In Part 3 the author shall deal with the angle of the secondment transaction vis-a-vis constitution of a Permanent Establishment, computation of profits and a flow chart.

“Secondment of employees and tax litigation – A perpetual battle" – Part 2

In the last article, the basic facts in relation to secondment of employees by the foreign entity to the Indian company were brought out. It was analysed whether the Indian entity can be treated as the employer of the secondees and whether it can be argued that no services are rendered by the foreign entity. The door of these two propositions appears to be closed because of judgment of the Apex Court and the Delhi High Court, though one can distinguish these judgments, if the facts otherwise permit.

In today’s article, we shall evaluate the angle of reimbursement and FTS.

Reimbursement

The most important facet of a typical secondment transaction is reimbursement of salary without any markup, which implies absence of any income element in the amount received by the foreign company. In such scenario, it can be very well argued that no income accrues to the foreign company. The Apex Court in case reported in [TS-5027-SC-2017-O] has categorically held that “Once the character of the payment is found to be in the nature of reimbursement of the expenses, it cannot be income chargeable to tax.”Even, in the context of secondment transaction, Courts have held that reimbursement of salary of secondees cannot be considered as income of the foreign company, in the following cases:

i. [TS-6745-ITAT-2012(Bangalore)-O] 

ii. [TS-6605-ITAT-2014(Bangalore)-O]

iii. [TS-5164-ITAT-2010(Mumbai)-O]

iv. [TS-7719-ITAT-2018(MUMBAI)-O]

v. [TS-6703-ITAT-2013(MUMBAI)-O]

The Delhi High Court in case of Centrica India Offshore Pvt Ltd. (supra) has not accepted the argument of reimbursement. As per this judgment it is incorrect to state that where services are provided between related parties, the demand of only as much money as has been spent in providing the service would remove the tax liability altogether. Further, this judgment has been followed in the following cases:

i. [TS-6082-ITAT-2015(Bangalore)-O]

ii. [TS-6588-ITAT-2017(Bangalore)-O]

iii. [TS-6722-ITAT-2016(Bangalore)-O]

iv. [TS-6326-ITAT-2019(Chennai)-O]

It may be noted that the above judgments are rendered prior to or without considering the judgment of the Apex Court in case of A.P. Moller Maersk (supra) and therefore, they can no longer be considered as a good law. The Pune ITAT in case of Faurecia Automotive Holding vs. DCIT (supra), while dealing with the issue of reimbursement of the salary of the secondees,preferredthe judgment of A. P. Moller Maersk (supra) over the judgment in case of Centrica (supra) and has held that reimbursement of salary, being without any income element, cannot be charged to tax.

Thus, reimbursement cannot be considered as income per se and therefore, the same cannot be taxed, irrespective of gross or net basis of taxation. The only impediment to the above argument is a case, where the services are provided to a related party which attracts transfer pricing adjustment. The same is dealt with later on.

To conclude, once the payment is mere reimbursement of expenses, there arises no tax implication. The subsequent discussion of FTS and Permanent Establishment (‘PE’) is without prejudice to the argument of reimbursement.

Fees for technical services/ Fees for included services (‘FTS’).

The Department’s main bone of contention is that the services rendered by the foreign company or the seconded employees on behalf of the foreign company is in the nature of technical services and therefore, taxable in India. The senior employees generally render services which are managerial in nature. They may also render services which are technical in nature for example the head of manufacturing division or R&D division etc. Thus, the services rendered by such employees fall within the meaning of the term FTS as defined in explanation 2 to section 9(1)(vii) of the Act. In fact, such definition also includes provision of services of technical or other personnel.

However, when one comes to DTAA, we have different treaties carry different definitions for this term. In some cases, the treaty employs the same meaning as given in the Act. In such case, the above rationale shall apply. However, in some treaties, FTSdoesn’t include managerial services within its ambit like DTAA between India-Netherland, India-UK, India-US and India-Canada. Thus, where only managerial services are rendered which are not technical in nature, in such case, the same cannot be considered as FTS/ FIS under these treaties [See [TS-6745-ITAT-2012(Bangalore)-O] (supra)].

The next important aspect is the ‘make available’ clause which is present in some of the treaties like the one withNetherland, Singapore, UK, US, Canada. The concept of making available the knowledge is quite well known. It has been explained by the Karnataka High Court in case reported in [TS-312-HC-2012(KAR)-O] in the following words “The service provider in order to render technical services uses technical knowledge, experience, skill, know-how or processes. To attract the tax liability, that technical knowledge, experience, skill, know-how or process which is used by service provider to render technical service should also be made available to the recipient of the services, so that the recipient also acquires technical knowledge, experience, skill, know-how or processes so as to render such technical services”

Thus, where the service provider apart from rendering the services also renders the skill, know-how etc. behind such services, in such a manner, that in future, the service recipient would not need the services, then it would amounts to make available of the technical knowledge.

In the context of the issue in hand, if the secondees are employed for some limited period of time, just to ensure that there are no initial hiccups in the operations of the Indian company or to assist the Indian company in trying something new, and after the initial services by such secondees such operations or tasks are performed by the Indian company through its own employees, in such case, it can be said that the technical knowledge, experience or skill has been made available. This has been explained by the Delhi High Court in case of Centric (supra) in para 32 as “The secondees are not only providing services to CIOP, but rather tiding CIOP through the initial period, and ensuring that going forward, the skill set of CIOP's other employees is built and these services may be continued by them without assistance. In essence, the secondees are imparting their technical expertise and know-how onto the other regular employees of CIOP.”In this case, the Court held that services rendered by the employees were fees for technical services since it made available the knowledge to the Indian entity. Similar conclusion is drawn in case reported in [TS-8950-ITAT-2018(Chennai)-O] and [TS-5440-ITAT-2020(Mumbai)-O].

However, in the following cases, the Courts have held that the condition of making available of technical knowledge was not fulfilled and therefore, the services of the secondees did not constitute FTS/ FIS - [TS-5141-ITAT-2012(CHENNAI)-O][TS-418-ITAT-2013(MUM)-O][TS-6703-ITAT-2013(MUMBAI)-O] etc.

From the above discussion, one may gatherthat where the job of the secondees is performed by the employees of the Indian company after such secondees depart, in such cases, the make available condition is fulfilled, but where the deputees are there perpetually for many years or where a particular job/ work performed by the secondees is completed without any similar job in future, in such case one can argue that no technology was made available by the foreign company.

Once the income is considered as FTS, then the same may be taxed on gross basis at the rates prescribed in DTAA or Act, whichever is more beneficial. However, the story does not end here. Whether or not the payment is considered as FTS, one will have to test the taxability under Article 7 dealing with business profits read with Article 5 dealing with Permanent Establishment.

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Note: One may also refer to Taxsutra Database Insight, wherein we have compiled 16  rulings in Part 2 & Part 3 which interpret on whether reimbursement of cost towards the services rendered by deputed employees/seconded employees tantamounts to "making available", the technical knowledge to Indian entity & hence taxable as fees for included services; deductibility of salary expenses of seconded employees upon constitution of service PE, what is crucial for bringing to tax and lots more!