The Hindu Business Line : Aztec Software ruling will increase cost of compliance

The recent decision by a Special Bench of a Tax Tribunal, that avoidance of tax is not a condition precedent for invoking transfer pricing and ‘arm’s length price’ (ALP) computation provisions of the Income-Tax Act, has come as a landmark verdict providing a shot in the arm for the Revenue and is likely to increase the cost of compliance for companies, according to legal and accounting experts who spoke to Business Line.

Stating that this is the very first transfer pricing dispute that has gone to a Special Bench, Mr Porus F. Kaka, a Mumbai-based advocate, said that the decision cannot be challenged before any other Division Bench of the Tribunal.

“In a sense it has acquired a finality, unlike others. From now on, every single international transaction above a certain limit must be at the ALP, which must be determined by all statutory authorities in appeal even if the order of the transfer pricing officer (TPO) is inadequate.”

Cost of compliance

In his opinion, the order will increase the cost of compliance in doing business in India “and is possibly unjustifiable even from the Revenue’s perspective. The fundamental flaw is perhaps an underlying belief in the tribunal that the ALP of every international transaction can be scientifically and accurately arrived at.”

According to him, transfer pricing is a subjective exercise to be carried out to establish the bona fides of the assessees at the time they enter into the transaction.

“Scientifically, there can never be only one exact ALP, which is recognised even by statutory provisions in Section 92C, which provides that when there are more than one ALP an arithmetical mean can be taken.”

He also said that the Tribunal could have realised that transfer pricing can never be an exact science, nor can there be only one ALP.

“Every single case will need to be remanded probably more than once, which actually happened in Aztec’s case. This will result in redoing of the entire transfer pricing assessment for assessment year 2002-03 in 2007. Such a delay would be a matter of extreme concern to foreign enterprises working in India.”

Pointing out that the Tribunal has relied upon the international OECD transfer pricing guidelines as being persuasive, he said that it is encouraging to note the attempt to align the country with the international accepted parameters.

High stakes

Though the verdict has come as a shot in the arm for Revenue, the ruling only signals the beginning of a long tussle between taxpayers and the Revenue since the stakes are so high, says Mr Abhishek Goenka, Partner, BMR & Associates, a professional services firm focused on the tax and regulatory area.

Speaking to Business Line on the implications of the ruling, he said that although the facts in the Aztec case are different from those of the captive units, many findings in the ruling will determine the course that pending proceed ings will take.

“The Commissioner Appeals earlier found several flaws in the procedures followed by the Revenue in completing the assessment and, more importantly, made a finding that transfer pricing regulations ought not to apply to a company that enjoys a tax holiday (as an STP unit under Section 10A of the I-Tax Act), since there could be no question of tax avoidance.”

But the Income-Tax Appellate Tribunal has now rejected the finding that transfer pricing provisions will not apply to companies enjoying a tax holiday.

“In its detailed and reasoned order, the Tribunal has dismissed allegations of legal infirmity in the procedures followed by the assessing officer. These findings are consistent with the ruling of the Delhi High Court in the Sony case.”

While dealing with the actual adjustments made, the Tribunal has referred the matter back to the assessing officer for re-determination of ALP.

Significant findings

“However, before doing so, it has made several findings which will have a significant bearing,” Mr Goenka said.

“It has upheld the Revenue’s position of using only single year data and has also commented on the insufficiency of a sample size of 10 companies being used.”

Besides, the Tribunal has criticised the TPO for rejecting the method adopted by the taxpayer without providing a basis, although no finding has been made on the most appropriate method. “It has also rejected the use by the Revenue of comparables from industry databases.” According to Mr Goenka, transfer pricing has emerged as one of the top most concerns of CFOs and tax managers of MNCs operating in India.

“Although such companies have been used to complying with and dealing with the nuances of transfer pricing in other jurisdictions, the absence of an advance pricing agreement mechanism coupled with a prolonged judicial process has led companies to believe that any form of certainty on transfer pricing matters will be a long wait.”

The situation was further aggravated by the orders passed by the Revenue towards the end of 2006 alleging that companies engaged in providing IT/ITES services on a captive model should have earned margins of 25-40 per cent, as compared to the typical 10 per cent margins adopted by such companies, he added.

“Most companies have appealed against the orders, but little progress has been made on the appeals and taxpayers are now faced with the prospect of similar orders being passed for future years. Aztec’s case was one of those that took a fast track, after the company appealed to the Commissioner Appeals when faced with an upward adjustment on its transfer price.”

It was to settle appeals filed by both sides against this order that the Income-Tax Appellate Tribunal set up a Special Bench, which passed the latest order.

Valuble insights

Stating that the transfer pricing assessments have caused much heartburn in the past four years due to huge tax demands, Dr Suresh Surana, a chartered accountant and founder of RSM-Astute Group, said that the ruling in question provides valuable insight into the manner in which the transfer pricing regulations should be applied, as there is limited guidance in this regard.

“The regulations, which were introduced with effect from assessment year 2002-03, empower tax authorities to adjust taxable income in case the ‘international transactions’ with associated enterprises are not on arm’s length basis.” According to him, one of the most important aspects of the verdict is that even if the assessee is entitled to deduction under Section 10A (available to STP/EOUs) the transfer pricing regulations would apply. Also, any adjustment on account of over pricing or under-pricing of international transactions will affect taxable income; and international transactions need to be at ALP.

Mr T. P. Ostwal, a Mumbai-based chartered accountant, said that had this been a case in the US, the IRS authorities would have considered the overall impact of the transaction keeping in mind the consequent tax avoidance or erosion in the country.

“The transfer pricing regulations were introduced to keep a check on erosion of tax base in India in case of a cross-border transaction between related parties. In the given case, the transactions were with the US, a high tax country; this aspect ought to have been kept in mind.”

Lastly, he said, the ITAT observed that unadjusted industry averages cannot be taken for ALP.

“It could have passed the order in favour of the assessee, instead of remanding the matter back to the assessing officer.”

Terming it a troubling judgment, largely for the assessee but also in a lesser form for the Revenue, Mr Kaka said: “It will cause major delays, especially when one considers that the whole basis of transfer pricing provisions are primarily to ensure that connected parties carry out transactions in a bona fide manner based on external contemporaneous data and not with a mala fide avoidance of tax. This seems to have been completely lost sight of and in fact rejected by the tribunal.”

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