The Apex court ruling on service tax implications on secondment of employees is likely to have adverse implications under direct tax

Facts of the Case:

M/S Northern Operating Systems Pvt Ltd. (Assessee) entered into an agreement with its group companies in foreign to provide back-office support and information technology support services to them at cost plus mark-up.
On Assessee’s request, the parent company had agreed to second certain employees to the assessee who will be engaged in proving managerial and technical services.
During such secondment, the employees were under supervision and control of the Assessee however, employees continued to be on payroll of the parent company merely for contribution or retention of social security, retirement and health benefits outside India.
Employees’ salary and out of pocket expenses which were paid by parent company were reimbursed by the Assessee.
Question before Supreme Court was to identify the true nature of the relationship between the seconded employees and the Assessee and was not concerned with the relationship between parent company and the Assessee

Held:

The Hon’ble Court observed that a single factor like operational and functional control over employee cannot be primary factor to determine whether an agreement is a contract for service or not. The Hon’ble Court has applied the test of “substance over form” considering the terms and objectives of the underlying secondment agreement.
It was noted that even though the control over seconded employees was with the Assessee, the fact remains that the seconded employees remain on the payroll of the parent company. Along with that they were entitled to social security benefits in parent entity’s jurisdiction. Therefore, it was doubtful whether without the comfort of this assurance, they would agree to the secondment.
The letter of understanding between the Assessee and the parent company nowhere stated that the seconded employees would be treated as employees of the Assessee during such secondment.
The Hon’ble Court concluded that the parent entity was real employer of the Seconded employees. Accordingly, it was held that the Assessee was the service recipient of the manpower recruitment and supply services provided by the parent company and thus liable to pay service tax on said services.

Likely Direct Tax Implications:

This ruling is a very significant ruling dealing with the controversial issue on secondment of employees by foreign company to its subsidiary in India. This issue has been hugely debated under the direct tax laws on applicability of with holding tax provisions and the likely exposure to constitution of Service PE.
Where the agreement dealing with the secondment of employees use to be carefully drafted to avoid any PE exposure in India, the above ruling seems to have concluded in a different way.
The “Substance Over Form” approach adopted by the Hon’ble Court will give teeth to the Income tax department to comeback to those assessees where such secondment agreement has been put in place.
Also, where it has been concluded by the Hon’ble Court that it is a contract for service by the Parent company to its subsidiary in India, the implication of it being held as Fee for technical services will also need a careful examination

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