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.
- 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 profitcompanies as comparables.
The tribunal addressed
Adjustments to comparables
It addressed whether the revenue authority failed to make
The tribunal referred to the Mentor Graphics decision and emphasised the finding that adjustments for differences between the comparable uncontrolled transaction and
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
In the present case, the taxpayer had been following an aggressive depreciation policy by following the standards under US GAAP including providing
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
- Nature or line of business
- Product or service market
- The assets composition employed
- Size and scope of
- 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
Accordingly, the tribunal held that the revenue authority erred in considering the use of certain comparables having income from other sources like interest on
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
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
Rejection of abnormally
The revenue had selected certain companies showing abnormally
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
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.
head of tax for KPMG in South India
senior manager – transfer pricing KPMG
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