Apart from the money involved, the case is important as tax talks between India and the US have got badly stuck on the issue of what kind of profit margins US firms need to declare for Indian tax authorities to accept them at face value there are 200 cases of US firms that are under dispute.
Given that the profit margins declared by Microsoft India are dramatically different from what the taxman thinks should be declared 16.4% versus 61.5%, respectively it is evident the dispute isnt going to end soon. Transfer pricing adjustments, such as the Rs 5,535-crore one with Microsoft, have risen from Rs 44,000 crore in FY12 to Rs 70,000 crore in FY13, before falling slightly to R60,000 crore in FY14 orders passed in FY14 pertain to returns filed in FY10.
As was the case last year, the taxman has disputed the profit margins given by Microsoft India. There is, however, a difference since, last year, the government notified safe harbour norms, which laid down profit margins above which the taxman would not scrutinise returns.
Interestingly, Microsoft has not declared profit margins in keeping with these norms; and the taxman has gone ahead and imputed margins that are significantly higher than those declared in even the safe harbour norms.
Take Microsoft Indias Bangalore ITeS unit, where the company has declared a profit margin of 15.9%. Under the safe harbour norms, the taxman was supposed to accept returns which declared a profit margin of 20%. While Microsoft has not declared the minimum margin under the safe harbour norms, and so opened itself up to scrutiny, the taxman has levied a margin of 29.86%.
While Microsoft India had given the examples of various firms to show why the 15.9% margin was correct, the taxman has argued the examples are not all valid.
It gets worse in the case of Microsoft Indias software development services unit in Hyderabad, where Microsoft felt a 16.4% margin was adequate as this was nothing but a contract R&D centre. Last year, the taxman had added back part of Microsofts global incomes to those of Microsoft India it had argued that since Microsoft Indias R&D contributed to Microsofts global profits, a share of the profits needed to be added back. This share was based on the proportion of R&D employees in India to the total across Microsoft operations.
This time around, the taxman has said that Microsoft Indias operations cannot be compared to those of Microsoft in the US since the quality of work done in the US was far superior more important, all the risk of the R&D not yielding results was being borne by the parent company, not the Indian operations.
The tax order, however, talks of how R&D is critical to profit margins the order points out that Microsoft Corps operating profit margins for 2009 were 53.5%.
While Microsoft India had given financials of what it considered appropriate contract R&D centres to arrive at its 16.4% margin, the taxman has, instead, said the centres profits should be compared with those of Infosys (45.47%), Wipro (73.35%) and some others. The Rangachary committees profit margins for contract R&D were 30%, or under half the 61.49% the taxman has levied on Microsofts software development operations for FY10.