At Arms Length- Landmark Ruling of ITAT on Transfer Pricing of Captive Software Company-
Mentor Graphics (Noida) Pvt Limited v/s DCIT (
Background
In a landmark Ruling pronounced in the open court by the Income Tax Appellate Tribunal (Tribunal) on November 2, 2007, the Tribunal decided certain fundamental issues relating to the Indian Transfer Pricing (TP) code. The case related to the Transfer Pricing of captive software development services rendered by an Indian entity to its overseas parent. The primary issue in the case was the methodology of selection of appropriate comparables for benchmarking the profits of the Indian taxpayer, in order to evaluate the adequacy (or otherwise) of the Transfer Prices between the Indian entity and its overseas parent.
The selection of appropriate comparables and the related analysis is the fundamental economic issue in any Transfer Pricing analysis. In the present case, the taxpayer had carried out a detailed Transfer Pricing analysis/ documentation and had chosen a set of comparables. Such set was however rejected by the Transfer Pricing Officer (TPO), and the TPO’s set was also upheld by the Commissioner (Appeals). The Tribunal, after undertaking an in-depth review of the taxpayer’s analysis and comparables set, as well as TPO’s set, reached certain fundamental conclusions, which would have far reaching implications on almost all Transfer Pricing cases in
Broad Conclusions of the Tribunal
(1) Transfer Pricing is not an exact science in which mathematical certainty is possible; some approximations cannot be ruled out. It needs to be prima facie shown that the transaction was properly examined, comparable prices were objectively fixed, in a bona-fide/ honest manner, as required by law.
(2) A proper study of all the specific characteristics of the transaction needs to be undertaken, including analysis of functions, assets and risks. The comparison needs to take into account economically significant activities and responsibilities of the enterprises. A mere broad comparison is not sufficient enough.
(3) Risks are an important consideration in any TP analysis, which are related to the economic principle that greater the risk, higher the return. In case of material differences in risks between the controlled enterprise and comparables, the identified comparables are not correct if appropriate adjustments for differences are not possible. Adjustments may be necessary for differences in working capital, risks and growth, R&D expenses, etc.
(4) Significant risks like market risk, contract risk, credit and collection risk, risk of infringement of IP etc. are critical factors to be considered. Similarly, level of assets and intangibles are important considerations for comparison purposes.
(5) Numerous financial ratios need to be examined and in-depth analysis needs to be undertaken in any Transfer Pricing analysis.
(6) The TPO’s order had several major and minor errors, which led to unsustainable results. As noted by the Tribunal, such errors in the TPO’s order included:
(i) The officer failed to consider the characteristics of the taxpayer’s transactions while finding comparables.
(ii) The TPO considered as comparables, companies having dealings with related parties, which is against the basics of Transfer Pricing.
(iii) Inferences and presumptions were used by the officer, which is not an authorized approach, as assessment is a judicial act and needs to be based on cogent material, not on unsourced presumptions.
(iv) The TPO failed to appropriately consider important issues like functions of the enterprises, size, intangibles owned, assets deployed etc. thus resulting in serious defects while selecting comparables. Total disregard of regulations, non-application of filters, etc. resulted in faulty selection of comparables. The Tribunal noted that such faulty selection is evident from the wide difference in the profit margins of the comparables chosen by the TPO.
(v) There was lack of application of mind and arbitrariness in the TPO’s order. The Tribunal observed that the officer was not justified in discrediting the comparables selected by the taxpayer in light of the fact that his own comparables set failed to satisfy the criteria and standards set by him. The TPO, in other words, arbitrarily rejected the taxpayer’s case.
(vi) It was not made clear why certain comparables chosen by the taxpayer were rejected by the TPO. Similarly, the economic rationale and consistency in respect of some of the screening factors used by the officer (like employee cost) was not free from doubt.
(vii) The TPO could undertake a fresh search only if the comparables chosen by the taxpayer were insufficient or deficient.
(7) In view of the above, the Tribunal did not approve the order of the TPO. The Tribunal observed that the taxpayer had carried out proper screening and detailed analysis while choosing comparables. The Tribunal, referring to a
(8) Based on the above in-depth examination, the Tribunal first selected one common comparable company appearing in the taxpayer’s set as well as the officer’s set and commented that as the taxpayer was earning more profits than this one company, it complied with the arm’s length standard.
(9) Further, the Tribunal constructed a smaller set of companies from the taxpayer’s set, choosing the companies not specifically rejected by the TPO. While preparing such reconstructed set, the Tribunal mentioned that it was not selecting high profit or high loss companies in such set, as the taxpayer worked in a no risk environment. The Tribunal also reached another conclusion that the entire range of such reconstructed set is representative of an arm’s length range, as in the open market, buyers and sellers would settle for a price anywhere in the range. Accordingly, the Tribunal held that so long as the taxpayer’s profits fall anywhere in the complete range of comparables, it was sufficient compliance by the taxpayer. The Tribunal held that the average/mean of results of comparables applied where multiple Transfer Pricing methods were being used and not where application of a single method resulted in multiple prices. Accordingly, the Tribunal concluded that any point in the entire range satisfies the arm’s length principle.
(10) The Tribunal deleted the Transfer Pricing adjustment to the taxpayer’s income made by the TPO and upheld the Transfer price of the taxpayer.
Conclusion
This landmark Ruling by the Tribunal is a step in the right direction, as it focuses on economic issues and recognizes commercial realities of businesses, which are the key in any Transfer Pricing analysis. The emphasis on a detailed functions, assets and risk analysis, as well as recognition of the no risk, captive, contract software development support service provider characterization of the taxpayer is an appropriate evaluation from a TP perspective. The Ruling also makes it clear that taxpayers need to undertake a detailed Transfer Pricing analysis while setting and documenting their Transfer Prices.
Further, the Ruling gives a direction to TPOs that once taxpayers undertake appropriate due diligence,their analysis cannot be arbitrarily rejected during audits based on inferences and presumptions.
In the backdrop of significant TP audit adjustments in
detailed evaluation of critical economic and commercial considerations; so that audits are smoother and TPOs have lesser chance to challenge Transfer Prices of such taxpayers.
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