The Hindu Business Line : Transfer pricing matters in captive software companies

On September 26, 2008, the Bangalore Bench of the Tribunal delivered an important judgement in the area of transfer pricing (TP). The Tribunal has dealt with the core transfer pricing issues relating to the trigger point for a Transfer Pricing Officer (TPO) to conduct a comparability analysis, the use of ‘contemporaneous’ data by ‘specified date’, rejection of related party transactions, quantification of risk and working capital adjustments and con firmation of safe harbour provisions.

This order relates to a TP adjustment to Philips Software Centre Private Ltd (‘the taxpayer’), a captive software development company, which had claimed tax holiday under Section 10A during the assessment year (AY) 2003-04.

In a lengthy order running to over 170 pages, the Tribunal has quashed the order of the TPO as being bad in law and on facts.

The Tribunal has also concluded that the international transactions of the taxpayer with its associated enterprises during AY 2003-04 satisfy the arm’s length test.

The key highlights of the Tribunal’s decision are:

Circular No.14/2001, issued by the CBDT, clearly mentions that the intention of the TP provisions is to curtail avoidance of taxes by shifting profits outside India.

The department representative’s (DR’s) reference to the provision dealing with the non-deduction of Section 10A benefit on a TP adjustment is out of context and irrelevant, as that provision comes into play only once a TP adjustment is made.

The DR’s reference to the Bangalore Tribunal’s decision in the Aztec Software case is incomplete, as that order clearly provides that the Tribunal’s observation was limited to the matter that no tax avoidance motive needs to be demonstrated at the time of initiation of the TP proceedings.

The Tribunal had not discussed as to whether the TPO or the assessing officer (AO) needs to demonstrate such a motive at the time of framing the assessment. In the instant case, the AO/TPO did not establish either at the time of initiating or concluding the proceedings, that the taxpayer had manipulated prices to shift profits outside India.

Further, since the taxpayer was availing itself of the tax holiday under Section 10A, it would be devoid of logic to argue that it had manipulated prices and shifted profits to an overseas jurisdiction for avoiding taxes in India.

Before the arm’s length price (ALP) is determined by the AO/ TPO, they have to satisfy and communicate to the taxpayer that at least one of the four conditions set out in Section 92C(3) have been satisfied, for applying the relevant TP provisions.

In the instant case, since the same was not done, the TPO’s order is void. The AO/TPO simply conducted their own analysis and applied the same to the taxpayer’s case. On the other hand, the taxpayer has discharged its onus by conducting a proper comparability analysis.

The taxpayer had followed a methodical search process starting with a set of companies that were potentially comparable and eliminating non-comparable companies through a filtration process. The taxpayer’s process resulted in a final set of ‘comparables’ that had survived elimination and were not companies that were ‘selected’, whereas the TPO had resorted to ‘cherry-picking’ comparables.

The TPO did not: (a) question the database used by the taxpayer; (b) question the data that emanated from such databases; (c) specifically reject the database used by the taxpayer; and (d) provide any reason for using the new database.

As there were no shortcomings in the method adopted by the taxpayer, the TPO was not justified in considering another method as the most appropriate method. Even where an infirmity has been identified, the action of the AO/TPO would be restricted to taking remedial action commensurate with such infirmity identified, and not beyond. The TP study conducted by the taxpayer could not be ignored since the TPO did not show any deficiency or insufficiency therein.

As regards the use of data of comparable companies for the analysis, the requirement of the law is two-fold:

(a) the data must relate to the financial year in which the international transaction has been entered into [Rule 10B(4), where the proviso is not attracted]; and

(b) such data should exist as by the ‘specified date’ [Rule 10D(4)]. The conditions in Rule 10B(4) and Rule 10D(4) are cumulative and if any one of them are not satisfied, the relevant comparable company ought to be excluded. Both the rules co-exist and should be read harmoniously; otherwise the taxpayer would be required to maintain two separate sets of documentation.

The taxpayer conducted its analysis by using a database in October 2003, which was reasonably close to the ‘specified date’ of November 30, 2003, whereas the TPO conducted a fresh comparability analysis beyond the ‘specified date’ by using data which was not ‘contemporaneous’, and hence, his analysis was not in compliance with Rule 10D(4).

As per Rule 10A(a), comparables having controlled transactions of even a single rupee of transaction by no means should be used as the basis for a comparability analysis and transfer pricing adjustment.

The following points need to be considered before concluding that the taxpayer operates in a risk-insulated environment:

(a) the taxpayer operates on a cost-plus model and is compensated for all the costs borne by it;

(b) the quantum of business of the taxpayer has consistently grown over the years; and

The list of captive companies which have made high profits (as forwarded by the TPO), cannot be used to arrive at a conclusion for allowing a risk adjustment as the list is flawed owing to:

(a) some companies not being captive service providers;

(b) the data being ‘secret comparables’ data’ that cannot be considered; and

Further, there are other captive companies who have earned margins in the region of 5 per cent to 10 per cent which the DR has not considered. This clearly shows that the DR was highlighting only companies at the higher end of the spectrum by ‘cherry-picking’ comparables without doing a proper Functions-Assets-Risks analysis.

Adjustments need to made to the comparable companies to eliminate differences on account of: (a) risk profiles; (b) working capital position; and (c) accounting policies (including for depreciation).

An adjustment on account of difference in risk profiles may be derived by subtracting the risk free ‘bank rate’ from the PLR. During the year in question, such difference worked out to 5.25 per cent. Even though the risk adjustment may be much more than that, to limit controversy, the said risk premium of 5.25 per cent must be considered as a risk adjustment.

As per Rule 10B(1)(e)(iii), an adjustment for working capital difference is required for an equitable comparison. In the instant case, the taxpayer had prepared a computation of working capital adjustment on PLR at 5.93 per cent. The computation of the taxpayer was on the lines of the draft guidance on comparability issued by the OECD.

In the absence of any specific statutory provisions, the TPO erred in ‘normalising’ the profits of super-profit making comparable companies by replacing them with profit margins of the next highest profit-making companies from the set of final comparables. Such companies should have been excluded from the list of comparables.

A standard deduction of 5 per cent on the ALP under the proviso to Section 92C(2) is available at the option of the taxpayer. The taxpayer’s case is squarely covered by the Kolkata Tribunal’s decision in the Development Consultants case.

The Delhi Tribunal’s decision in the Mentor Graphics case and the Pune Tribunal’s decision in the E-gain Communication case are squarely applicable to the taxpayer’s case. While dealing with the commonalities, amongst others, the Bangalore Tribunal observed that the net profit margins of Mentor Graphics and E-Gain Communication were 6.99 per cent and 5.16 per cent on cost, respectively, and that of the taxpayer was 5.91 per cent on cost.

Even based on a ‘accept/reject’ test of the comparables of the TP study and the TPO’s comparables, as prepared by the taxpayer, the transactions of the taxpayer with its associated enterprises satisfied the arm’s length test.

Landmark ruling

This is a landmark judgment which has clarified a number of issues affecting the taxpayer in the field of transfer pricing. The dominant theme of this order is that the discretion granted under the law to the tax authorities on transfer pricing matters is not unfettered. It has to be within the framework of the Act and Rules, reasonably exercised and utilised for the purposes for which it was granted.

In general, the transfer pricing analysis prepared by the taxpayer stands, unless the tax officer rejects it as being completely flawed. In the absence of such a rejection, the tax officer cannot deviate from the taxpayer’s analysis except on specific issues where the taxpayer is shown to be wrong.

(The authors are Partner and Director, respectively, BSR & Co.)

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