E-Gain wins transfer pricing victory

The Pune Tax Tribunal has passed an order confirming the principles laid down by the Mentor Graphics transfer pricing decision. E-Gain, an Indian taxpayer, was a captive service provider operating on a cost plus 5% basis, providing software services to its parent. The company had undertaken a study including the justification of its arm’s length price using the TNMM basis to justify its results. The revenue authorities had proposed and concluded a TP adjustment at 16.12% on costs, on the basis of 20 comparables chosen.

In this case the tribunal was faced with the following issues:

• The need of specific adjustment for differences between the tested party and comparables in applying the Transactional Net Margin Method (TNMM);

• The exclusion of non-operating incomes in computation of operating margins of certain comparables;

• The use of specified turnover criterion in selection of comparables;

• The appropriateness of selection of certain abnormally high profit companies as comparables.

The tribunal addressed specially each of the referred issues, after taking due recognition of the facts of the taxpayer, the transfer pricing provisions under the Income-tax Act, 1961, the OECD Transfer Pricing Guidelines and US regulations as applicable.

Adjustments to comparables

It addressed whether the revenue authority failed to make adjustment for the differences in comparable transactions. The tribunal held that while comparing transactions or companies, the differences which are likely to materially affect the price, cost charged or paid in, or profit in the open market are to be taken into consideration with the idea to make reasonable and accurate adjustments to eliminate differences having material effect. Te tribunal further highlighted if the differences between comparables and the tested party cannot be subjected to an evaluation, then transaction may be eliminated for purpose of comparison.

The tribunal referred to the Mentor Graphics decision and emphasised the finding that adjustments for differences between the comparable uncontrolled transaction and international transaction is necessary. Necessary adjustments for differences on account of FAR analysis and other relevant factors needs to be made while applying TNMM.

The tribunal decided that the TNMM may afford a practical solution to otherwise insoluble transfer pricing problems if it is used sensibly and with appropriate adjustments to account for differences.

It would be pertinent to note that rule 10B(3) of the Income-tax Rules 1962 provides that an uncontrolled transaction should be comparable to an international transaction if there are no differences that materially affect price/margin or reasonably accurate adjustments to account for such differences can be made. Indian regulation expressly require that adjustments to prices/margins should be made (where appropriate) to enhance comparability.

In the present case, the taxpayer had been following an aggressive depreciation policy by following the standards under US GAAP including providing deprecation in excess of the rates required to be worked out under the Indian Companies Act 1956 and as provided in the Schedule XIV of the referred Act. The taxpayer had accordingly claimed that depreciation needs to be worked out under the provisions of the Companies Act, 1956 and carried out an adjustment to its margins. This was upheld by the tribunal.

Factors to be examined for identifying differences for the purpose of comparability

The tribunal said that the comparable companies and the taxpayer were not scrutinised by the tax authorities to find out the differences, which needed adjustments. The relevant factors affecting comparability of the transactions being:

• Nature or line of business

• Product or service market

• The assets composition employed

• Size and scope of operations,and

• Stage of business or product cycle

The tribunal held that any difference that materially affects the market value is to be given serious consideration. In this case the fact that some of the comparable had non-operating incomes or operative incomes attributable to assets other than assets under consideration is to be adjusted before any comparison.

Accordingly, the tribunal held that the revenue authority erred in considering the use of certain comparables having income from other sources like interest on deposit , dividend income and income from sale of licences, which had jacked up profit margin of these companies. Should an adjustment for exclusions of such incomes not be possible, than such companies should be dropped as comparables.

The revenue had included in its analysis certain comparable companies having lines of business different from the business of the taxpayer. The tribunal agreed with the contentions of the taxpayer that these companies were not engaged in software development activities and was the view that such companies be excluded for comparability.

Application of turnover filter in applying comparables

The taxpayer contended that the revenue was in error in selecting comparable companies without applying appropriate sales filter. The Tribunal was of the view that it saw no justification for considering oversized companies as taken by the revenue. However, the tribunal was of the view that sales cannot be considered as the only relevant factor for proper comparability analysis and various other factors such as FAR analysis would also required to be undertaken. Should this not be done, the comparison would be unsound and unreliable.

Rejection of abnormally high profit comparables

The revenue had selected certain companies showing abnormally high profit margin in proposing the adjustment. In this regard, the tribunal held that it was necessary to examine whether these entities have been rightly taken as comparables. The tribunal relied on para 1.47 of the OECD TP Guidelines. Should an application of a process produce a range of figures, a substantial deviation amongst points in that range may indicate that the data used in establishing some of the points may not be as reliable as the data used to establish the other points in the range. In short, the deviation may result from features of the comparable data that require adjustments and in such cases further analysis is a necessity. In the instant case, the revenue authorities were in error in not making the adjustments. The Tribunal held in its ruling that the revenue should ignore certain oversized companies while calculating the average industry profit for the purpose of transfer pricing.

This ruling is an important one as it has highlighted the importance of the TNMM method as one that may afford a practical solution to otherwise insoluble transfer pricing problems and gone into detailed analysis of comparable data. The Tribunal has reiterated the importance of FAR and the need of adjustments and should this not be done, the comparison be treated as unsound and unreliable.

With the tax tribunal’s decision on the principles, it needs to be seen as to how they are accepted and followed by the revenue. Practical implementation of material differences and adjustments would be a challenging task but if it were to be done in a judicious manner, it would be a good defence strategy to establish the arm’s length standard.

KR Girish

head of tax for KPMG in South India

krgirish@kpmg.com

Hardev Singh

senior manager – transfer pricing KPMG

hardevsingh@kpmg.com