Column Rules of transfer pricing

Font Size

Print

Feedback

Email

Discuss

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.

Another key issue addressed by the Tribunal in its ruling relates to the erroneous approach adopted in considering certain “oversized companies” for the purpose of comparison with the taxpayer. The Tribunal pointed out that the use of the specific turnover criteria cited by the CIT(A) in his order was appropriate and also observed that in case of comparable companies with extraordinary profits, it would be prudent for the tax authorities to evaluate whether the said companies ought to be considered as comparables. However, the Tribunal did not dwell upon what other factors are to be looked into for considering certain companies as oversized companies. In the backdrop of the above ruling, one may argue whether abnormally high-profit making companies need to be rejected or not while interpreting the meaning of “oversized companies”.

The Tribunal accepted the contention of the taxpayer that as the line of business of certain comparable companies was different from the business of the taxpayer, the said companies were to be excluded.

This ruling is a step in the right direction, as it focuses and reaffirms the importance of comprehensive functions, assets and risks analysis for identifying and selecting comparable companies. It is a welcome relief to taxpayers, as it provides assurance that the powers conferred on the revenue authorities would need to be exercised in a prudent manner.