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Transfer pricing vs IT: A case of wrong comparables

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Mr Hitesh Gajaria, Partner, BSR and Co.
Mr Hitesh Gajaria, Partner, BSR and Co.

D. Murali

Chennai, Dec. 21

The taxman has rattled the IT (information technology) industry with the transfer-pricing (TP) orders.

According to reports, scores of companies in Bangalore and Hyderabad have come under the Income-Tax Department's lens, with their transfer pricing adjustments in question.

For starters, `transfer price' is the price at which a company's divisions transact with one another. "Increasing participation of multi-national groups in economic activities in the country has given rise to new and complex issues emerging from transactions entered into between two or more enterprises belonging to the same multi-national group," begins a page on `transfer pricing law in India' on http://incometaxindia.gov.in. Sections 92A to 92F of the Income-tax Act, speak of computation of income from an international transaction having regard to arm's length price.

To know more about the issue, Business Line contacted Mr Hitesh Gajaria, Partner, BSR & Co, Mumbai. Here is his take on a few questions:

What is the issue?

If the 80-odd cases selected by the TP authorities for higher tax adjustment are captive software service, or captive ITES (IT enabled services) such as back-office service providers, which have been benchmarked against margins earned by public listed companies, then it is indeed an unfortunate miscarriage of the transfer pricing principles. Support has been drawn from generic industry publications such as Nasscom Strategic Review 2006 and the like.

Why so?

Because, these comparables are bearing all economic risks of doing business, whereas the captives operate in a near risk-free environment.

With economics governing the commercial world, margins earned are a result of three interplaying variables, viz. functions performed, assets utilised, and risks borne, or FAR, in short. Most importantly, higher the risks undertaken, higher are the expectations of rewards (margins). Captives do not bear most economic or business risks, and consequently can never be compensated on a basis comparable to riskbearing companies.

Are margins in question?

Economic analyses connected with the offshoring of business processes have pointed to a total cost saving of about 10-20 per cent after these captive units are compensated on an arm's length basis of cost plus approximately 10-12 per cent.

What happens if captive units are forced by the TP officers to adopt margins as high as 25 per cent for software service companies, and 37 per cent for ITES companies?

In most cases this would defeat the very purpose of offshoring and these units would rather leave the shores of India to more competitive destinations such as Romania, the Philippines, Hungary and so on.

There could be other consequences, too.

Yes, negative implications include: loss of jobs for thousands of graduates that Indian universities churn out; loss of tax on salaries and the FBT (fringe benefit tax) that these employers deduct/ deposit with the Government; slowdown in economic activity; and crucially, loss of confidence by foreign investors in the fair and even-handed implementation of the country's tax system.

On the one hand the Government is doing everything to encourage the development of India as a service centre of the world, while on the other, actions by some overzealous officers precisely destroy this promise.

The outcome, as you see it?

Justice may well prevail ultimately, but given the slow judicial system and the uncertainty, how many affected captives will survive is the moot question.

(This article was published in the Business Line print edition dated December 22, 2006)
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