TPO accused of cherry-picking comparables

India is lacking an extensive source of R&D comparables

The Mumbai Income Tax Tribunal (ITAT) has sent back the file of Teva India, dealing with pharmaceuticals, to the transfer pricing officer (TPO) to reassess whether Vimta Labs, a contract research and testing organisation with abnormally high profit, is comparable to a contract R&D provider.

TPOs have been using Vimta Labs to argue that contract service providers warrant a high cost plus mark-up.

This is in line with the Delhi Tribunal's ruling, in the case of Adobe Systems, where it was held that abnormally high-profit-making comparables cannot be compared with risk-free captive service providers.

Teva filed its income return for the assessed year in October 2004 declaring Rs6,768,933 ($150,537).

In the assessed year, Teva had provided R&D services to its overseas associated enterprises (AE), which had compensated it on a cost-plus 10% mark-up.

In the transfer pricing analysis Teva had adopted the transactional net margin method (TNMM) as the most appropriate method to determine the arm's-length price for the transactions.

Teva identified certain companies as comparables for the transactions engaged in R&D and other business support services. The company said it had conducted a search for companies engaged in R&D but, since it did not get an adequate number of comparables, the search had to be widened.

A search was therefore conducted for comparables that perform similar functions at a broad level and comparables providing other business support services were selected.

Teva said, in its submission, that financial data for financial year 2003 to 2004, for all comparable companies, were not available at the time of undertaking the transfer pricing study. As a result, the financial data used for financial years 2001 to 2002 and 2002 to 2003, were used for some comparables.

The arithmetic mean of the margins earned by comparable companies was worked out to be 8.59% on operating costs.

During 2003 to 2004 Teva had earned an operating margin of 11.73% on operating costs from the provision of R&D to its AEs and the pricing for these transactions was considered arm's-length by Teva in accordance with section 92(1) of the Income Tax Act.

The assessing officer (AO) referred the case to the TPO for the determination of the arm's-length price.

While the TPO did not disagree with the method or the adopted search criteria, he did disregard the arm's-length margin.

The TPO instructed Teva to conduct a fresh search with consideration for financial year 2003 to 2004. On completion of this search the TPO computed an arm's-length margin of 33.26%.

The TPO accepted the result of the fresh search for comparables selected by Teva, but ignored some companies because they were not functionally comparable.

Teva filed an appeal, disputing the TPO's adjustment. Teva maintained its use of the companies ignored by the TPO was correct saying that, without comparables providing R&D at arm's length, it had to widen its search.

Teva maintained the use of the TNMM requires that net margins, from an international transaction, should be compared with net margins from an uncontrolled transaction. It does not require product-wise or service-wise product comparability. This, said Teva, is in line with OECD guidelines.

During the tribunal Teva submitted that the search strategy was not rejected by the TPO and the comparables selected by the TPO himself also included comparables engaged in activities other than R&D, such as Water & Power Consulting Services (India), Alphageo (India) and NIS Sparta.

The TPO was therefore accused of "cherry-picking comparables by eliminating loss making, or low profit making comparables, even though they carried functionally similar activities rather than adopting an objective approach in identifying and screening the comparable companies".

Teva said that according to section 92C(2) of the Income Tax Act, it has the option of charging a price to its AEs, which may vary from the arm's length price by ±5%. The company contended that it should be allowed the benefit of ±5% variation from the arm's-length price as per section 92C(2) of the Act.

Teva named a number of other cases that supported the ±5% claim including Sony India (P) Ltd. vs DCIT and vice versa [(2008) 118 TTJ 865], Philips Software Centre Private Limited vs ACIT = [(2008) 26 SOT 226], Development Consultants Pvt Ltd vs DCIT = [115 TTJ 577], Skoda Auto India Pvt Ltd = [(2009) 122 TTJ 699] and Customer Services India (P) Ltd [(2009) TIOL 424].

On the question of risk assessment, the tribunal referred the case back to the AO.

The case is supported by previous decisions.

The Tribunal directed the TPO to consider risk-adjustment as Teva was a contract R&D service provider with guaranteed cost plus 10% markup.

"The observations of the Tribunal that comparables having losses should not be excluded, only on the ground of losses, except in cases where there are other factors justifying the exclusion of the companies, would assist taxpayers as the Revenue at the field-level has not been accepting loss making comparables. This principle was also held in the Chandigarh Special Bench case of Quark Systems", said Manisha Gupta of Deloitte Haskins and Sells.

The case also raises the concept of entrepreneurial risk.

"There is very limited guidance on entrepreneurial risk adjustment in India," Jain added. "There is only one ruling that talked about the mechanics of carrying out this adjustment – Philips ruling, Bangalore Tribunal. Most of the other rulings, for example: Cordys R&D, Hyderabad and SAP Labs, Bangalore, touched briefly on the fact that risk adjustments should be allowed, without getting into the mechanics of the same. That's the only silver lining at the moment."

The case has led to call for an introduction of the inter-quartile range in India. For more on this read this issue's cover story.