Column Rules of transfer pricing

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Endowed with the advantages of low-cost base and a large, growing English- speaking workforce, India has emerged as a globally preferred outsourcing destination. The growth achieved by India’s information technology (IT) services and information technology enabled services (ITeS) sectors stand testimony to this.

Indian transfer pricing regulations require captive units having international transactions with its associated enterprises to be remunerated on an “arm’s-length” basis, leading to the often vexed question of what constitutes an arm’s-length remuneration for a captive unit. Indian tax courts have delivered some important decisions dealing with transfer pricing issues, including the basis for determination of arm’s length price. One such recent decision by the Pune bench of Income Tax Appellate Tribunal (‘the Tribunal’) is in the case of E-Gain Communication Private Limited, which deals with certain fundamental transfer pricing issues relating to selection of comparables, adjustment for differences between controlled and uncontrolled transactions, importance of functional analysis.

E-Gain, an Indian taxpayer, was a captive unit operating on a cost-plus-5% basis and providing software services to its parent company. The taxpayer had undertaken a study including the justification of its arm’s length price using the transactional net margin method (TNMM). The transfer pricing officer (TPO) had proposed and concluded a transfer pricing adjustment at 16.12% on costs, on the basis of 20 comparables chosen. On further appeal, the commissioner of income-tax (appeals) [CIT(A)] upheld the order of the TPO.

The Tribunal, after examining the relevant provisions of the Indian transfer pricing regulations, deleted the adjustment made by the TPO. The Tribunal relied on the decision of Mentor Graphics (P) Limited [2007] 18 SOT 76 (Del), the relevant provisions of the OECD’s guidelines on transfer pricing and the US transfer pricing code and addressed the following key issues:

While addressing the issue relating to adjustment to comparables, the Tribunal held that at the time of comparing the controlled and uncontrolled transactions under the TNMM, the differences having material effect on price, costs or profit, as the case may be, are to be taken into consideration to make reasonable and accurate adjustment to eliminate such differences.