Mumbai: In a major relief to foreign firms outsourcing business process in India , the Supreme Court has held that these captive BPOs are not liable to be taxed in the country if they are billing the subsidiaries on an "arms length" basis or without giving any preference.

The judgement came on a case between US investment bank Morgan Stanley and the income tax department. The department had said that outsourcing activities by Morgan Stanley Advantage Services (MSAS), the firm''s Indian arm, must pay tax in India.

A bench headed by Justice S H Kapadia said MSAS was not a permanent establishment (PE) as it was performing only back office operations in India and cannot be taxed under PE rules, and upheld an order of Authority for Advance Ruling (AAR).

"There was no agency PE as the PE in India had no authority to enter into or conclude the contracts. The contracts would be entered in the US. The implementation of those contracts only to the extent of back office functions would be carried out in India," the bench said.

The apex court ruling is likely to benefit foreign companies like GE, HSBC, Standard Chartered Bank which outsource back office functions to their Indian units. Foreign companies operating in India pay tax at a rate of about 42 per cent and the judgement establishes that income of subsidiaries on work done for parent companies was not taxable.

Tax consultant Mukesh Butani, partner, BMR & Associates, said it was a big relief for captive BPOs as the apex court had ruled on two important principles.

"One, stewardship activity does not constitute a PE. Second, if the Indian BPO is remunerated on arm''s length basis, no further income of MNC can be attributed to India," he said.

Tax experts say the ruling will help the BPO sector, which has been under increasing pressure from the income tax, or I-T, department.

The income tax department had gone in appeal against the Advance Ruling Authority ''s order in the Morgan Stanley case. But the division bench of Justice Pasayat and Justice Kapadia has confirmed the Authority for Advance Rulings, or AAR, ruling.

The AAR had held that as long as the transactions between the global parent and the Indian subsidiary is on arm''s length basis, no part of global profits of Morgan Stanley would be attributable or taxable in India.

The Supreme Court ruling could also have an impact on MNC taxation and may overrule the Mumbai Income Tax Appellate Tribunal, or ITAT, order in Sony''s case, which had taken a contradictory position to the AAR.