Employee secondments involving IP transfer - Evaluating TP implications

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Employee secondments involving IP transfer - Evaluating TP implications superadmin Tue, 06/05/2014 - 13:13

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Within a multinational group, it is relatively common for employees of one company to be temporarily seconded to another company of the group and to perform business activities that belong to the business of that other company. In such cases, administrative reasons often prevent a change in the employment contract. Some countries might consider that the services rendered by the seconded employee are services provided by the first company to the second company. Since paragraph 10 of the OECD Commentary on Article 5 provides that an enterprise carries on its business through its employees, it would be difficult to consider that a foreign enterprise did not have a permanent establishment (PE) in the situation where the personnel are formally employed by the foreign enterprise unless it was found that the personnel were in fact “economically” employed by the other company. As stated in the 2012 OECD’s Discussion Draft on PE, the analysis described in paragraphs 8.13 to 8.15 of the OECD Commentary on Article 15 will be relevant for the purposes of distinguishing these cases from other cases where employees of a foreign enterprise perform that enterprise’s own business activities.

In a recent ruling in the case of Centrica India Offshore Pvt. Ltd. [TS-237-HC-2014-DEL] the Delhi High Court (HC) ruled on tax implications arising from cross-border secondment arrangements. Having regard to the facts of the case, the HC held that the employees seconded by the overseas associated enterprises (AE) to the Indian affiliate did not become employees of the Indian affiliate, but continued to remain employees of the AEs during the secondment period. Accordingly, the arrangement involved provision of services by the AEs to the Indian affiliate through such seconded personnel. Furthermore, payments made by the Indian affiliate for such services would be regarded as fees for technical services (FTS) under the Indian Tax Laws (ITL), as well as under the relevant Double Taxation Avoidance Agreements (DTAAs). The HC also concluded that the AEs created a Service PE in India under the applicable DTAAs by virtue of services rendered through the personnel present in India.

While the ruling does raise a number of issues relating to existence of PE, characterization of income and applicability of “short stay exemption” in case of such individuals, this article seeks to address the transfer pricing (TP) aspects that need consideration in light of the ruling.

Secondment Arrangements involving transfer of intangible property (IP)

While addressing the question relating to appropriate characterization – whether FTS or not – of the payment made by the Indian affiliate, the HC observed that the foreign enterprise is imparting technical expertise and know-how to the Indian affiliate through the seconded personnel. The secondment, if viewed from this angle, leads to a benefit that transmits the knowledge possessed by the seconded personnel. According to the HC, the DTAA contemplates not only a formal transfer of intellectual property, but also other techniques and skills (“soft intellectual property”, if it can be called as such) required for the operation of a business. These observations raise a question on whether secondment arrangements between AEs should be evaluated as IP transactions and priced accordingly from a TP perspective.

A definition to the term “intangible property” for TP purpose was introduced in the ITL by the Finance Act, 2012. The definition, in addition to covering generally accepted items of marketing and technology related intangible assets, also includes human capital related intangibles such as trained and organized workforce and employment agreements, even though an employment agreement would not have a value independent of the services of any individual. The objective of the ITL in covering employment agreements within the definition of IP appears to be to deal with situations where there is a transfer of a right to exploit valuable know-how which may occur by way of assignment of skilled employees. As it is often difficult to distinguish between transfers of know-how on the one hand, and the ordinary reassignment of skilled employees, it appears that a law has been proposed to cover all cross-border assignments within the scope of transfer of IP by defining IP to include “employment agreements.”

It may be noted that the German tax authorities published a circular on cross-border secondment of employees (Administrative Principles: Secondment of Employees dated 9 November 2001), which is focused on principles of the income allocation in cases of cross-border secondments. According to the circular, in case of secondment of employees it has to be examined whether the assignment of an employee includes the transfer/permission to use certain knowhow for which unrelated parties would have established a specific compensation. Therefore, an assignment of employees could trigger an IP transaction if the transfer of IP was associated with the assignment.

The effect of classifying employment agreements/ secondment of personnel as an IP may result in allocating a portion of the income attributable to IP to the foreign enterprise that provides the seconded personnel, effectively treating these special skills of individual employees as IP. Whether a secondment arrangement should be looked at as an IP transaction from a TP perspective, will very much depend on the nature of the “assumed” IP and on whether this is personal to the employee or owned by the seconding company. Once the assumed IP has been identified and it reveals itself to be personal to the individual, e.g. professional knowhow, then it is unlikely that it will constitute a transfer of an IP. If it is established that the assumed IP is owned by the seconding company but its effective use transfers to the secondee company as a result of the secondment, and the IP is valuable, then it will most probably constitute a transfer of an IP and an appropriate arm’s length price will have to be established.

Profit attribution to PE

Having regard to the substance of the employment relationship, the HC ruled that the secondment of personnel created a Service PE of the foreign AEs in India. Even though services in the nature FTS are specifically excluded from the Service PE rule, nevertheless, the conclusion by the HC that the personnel were in substance employees of the foreign AEs could result in a question on possibility of a fixed place PE as well. In any case what may be taxed in India are profits that are attributable to that PE.

The “authorized OECD approach” or AOA, states that the profits attributed to a PE are the profits that the PE would have earned at arm’s length, in particular in its dealings with other parts of the enterprise, as if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the PE and through the other parts of the enterprise. The AOA is a two-step analysis. The first step consists of the elaboration of a functional and factual analysis that is intended to hypothesize the PE as a separate and independent enterprise, which performs functions, owns assets, assumes risks and enters into “dealings” with the enterprise of which it is a part and with other related or unrelated enterprises. In the second step, the profits of the hypothesized separate and independent enterprise must be determined by applying, by analogy, the OECD TP Guidelines.

Dealings between the PE and the enterprise are real and identifiable events of economic significance that occur within the PE context. The recognition of such dealings is a critical factor in the correct application of the AOA. It is the functional and factual analysis that would validate the dealing for the purposes of the AOA. Under a typical secondment arrangement, a real and identifiable “dealing” can be the temporary transfer of employees by the Head Office (HO) to perform the activities for the PE. The functional and factual analysis may determine that the PE is providing a service to the Indian affiliate on behalf of the HO. Depending upon the facts of the case, the provision of service may involve transfer of know-how or IP by the PE to the Indian affiliate. Once the first step has been performed and the dealings between the PE and the enterprise have been identified and characterized, they should be priced at arm’s length. The arm’s length remuneration of dealings should then be determined by applying the methods provided for in the OECD Guidelines.

In the case of Morgan Stanley & Co (284 ITR 260), a US company had entered into a service agreement with an Indian affiliate providing back office support to its principal and had seconded staff to the affiliate. The Supreme Court considered that, although the affiliate did not constitute a PE of the US company, the seconded personnel did. However, as the remuneration paid to the AE was at arm’s length, there was nothing to be taxed in the PE. The Supreme Court also observed that the situation would be different if the transfer pricing analysis does not adequately reflect the functions performed and the risks assumed by the (multi-national) enterprise. In such a case, there would be a need to attribute profits to the PE for those functions/ risks that have not been considered. Identification and characterization of the “dealings” between the HO and the PE and functional and factual analysis regarding the dealings would be critical in determining if there are any additional functions/ risks/ assets for which profits may be attributed to the PE. The conclusion could vary depending upon the role of the seconded personnel as well as the operating model of the secondee company.

Multi-national enterprises operating in India may need to consider the impact of the ruling on their existing secondment arrangements and consider options for managing risk.

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