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Management | Landmark transfer pricing ruling gives taxpayers some relief

Management | Landmark transfer pricing ruling gives taxpayers some relief
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First Published: Mon, Nov 26 2007. 12 56 AM IST

Updated: Mon, Nov 26 2007. 12 56 AM IST
A recent landmark transfer pricing ruling, pronounced on 2 November 2007 by the Income Tax Appellate Tribunal, reaffirmed the principle that transfer pricing is not an exact science in which mathematical certainty is possible and that some approximations cannot be ruled out.
Hence, the tribunal ruled that it needs to be prima facie shown that the related party transaction was properly examined and that comparable prices were objectively fixed in a bona fide or honest manner, as required by law.
The ruling also makes it clear that taxpayers need to undertake a detailed analysis while setting and documenting their transfer prices with related parties. Further, the ruling gives a direction to tax officers that once taxpayers undertake appropriate due diligence, their analysis cannot be rejected arbitrarily during audits based on inferences and presumptions.
The subject case related to the transfer pricing of captive software development services rendered by an Indian entity to its US parent.
The primary issue involved was the methodology used to select appropriate comparables for benchmarking the profits of the Indian taxpayer, in order to evaluate the adequacy (or otherwise) of the transfer prices between the Indian entity and its US parent.
In this particular case, the tax authorities made an upward adjustment to the taxpayer’s income by not accepting the comparability analysis documented by the taxpayer.
Simply put, a comparability analysis is made by comparing a related party transaction with an unrelated party transaction to demonstrate that the related party transaction meets the arm’s length standard.
The matter reached the tribunal where certain fundamental principles relating to the Indian Transfer Pricing Code were decided. Among other things, the tribunal held that a proper study of all the specific characteristics of the transaction needs to be undertaken, including analysis of functions, assets and risks.
The comparison needs to take into account economically significant activities and responsibilities of the enterprises. A mere broad comparison is not enough. Risks are an important consideration in any transfer pricing analysis, which are related to the economic principle that the greater the risk, the higher the return. In the case of material differences in risks between the controlled enterprise and comparables, the identified comparables are not correct if appropriate adjustments for differences are not possible.
As per Indian regulations, appropriate adjustments are required to be carried out to sustain comparability. Where the adjustments do not necessarily bring the proposed comparable nearer to the taxpayer, comparability cannot be made. The tribunal emphasized that these regulations have the force of law.
The tax officer’s order had several major and minor errors, which led to unsustainable results and thereby, upward adjustment to the taxpayer’s income.The tribunal disregarded certain inferences and presumptions made by the audit officer and constructed a smaller set of companies from the taxpayer’s set.
While preparing such a reconstructed set, the tribunal mentioned that it was not selecting high-profit or high-loss companies in the set, as the taxpayer worked in a no-risk environment, being a captive.
The tribunal also concluded that the entire range of such a reconstructed set is representative of an arm’s length range, as in the open market, buyers and sellers would settle for a price anywhere in the range. Accordingly, the tribunal held that as long as the taxpayer’s profits fall in the complete range of comparables, it was sufficient compliance by the taxpayer.
The tribunal held that the average/mean of results of comparables applied where multiple transfer pricing methods were being used, and not where the application of a single method resulted in multiple prices.
Accordingly, the tribunal concluded, in favour of the taxpayer, that any point in the entire range satisfies the arm’s length principle.
It is important to note at this juncture that the tribunal is the second level appellate authority and the final fact finding appellate authority. Appeals against the tribunal’s ruling on legal issues are possible before the high court.
An area of concern is that the ruling continues to uphold the tax department’s position that the arm’s length price has to be determined by considering data of the current year.
Let us take an instance to understand how this works. Let’s say a taxpayer is preparing his documentation for the year April 2006-March 2007 (FY07), which is mandatorily required to be in place by 31 October 2007 (in the case of a company).
When this documentation is being prepared by the taxpayer, he is not in a position to get adequate public data of comparables for the same period and hence he would use the historical data available at that point in time. Subsequently, when the tax department audits this company during FY08 or FY09, adequate data for FY07 is readily available in the public domain. The FY07 data (referred to as the current year data) will then be used by the tax department to determine the comparable arm’s length price.
This approach could lead to upward income adjustments and has been experienced by taxpayers across the country in past audits. Therefore, the issue being raised is whether the taxpayer should be subjected to such a harsh compliance requirement which has an element of “impossibility of performance”. If one goes by the tribunal ruling that any point in the entire range satisfies the arm’s length principle, then there is not much of an issue even if the current year data is used.
However, if this legal issue is challenged, and the arithmetic mean of the entire range is used, the taxpayer’s hardship continues. One will need to allow some time till these issues are settled.
Notwithstanding the concerns, the ruling comes as a welcome relief to taxpayers, as it provides some assurance that taxpayers undertaking due diligence and detailed or robust analysis are better placed to face intense transfer pricing audits in India.
Further, the ruling gives a direction to audit officers that once the taxpayers undertake appropriate due diligence, their analysis cannot be arbitrarily rejected during audits based on inferences and presumptions.
Sanjay Tolia is executive director, transfer pricing, PricewaterhouseCoopers. Ketan Dalal will return with the next column. Respond to this column at groundrules@livemint.com
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First Published: Mon, Nov 26 2007. 12 56 AM IST