The ruling is significant as it comes from the Special Bench – a superior court - and therefore has more force,” said Sanjiv Malhotra of BMR Advisors.
According to Malhotra the ruling is a “U-turn” because it contradicts the trend of previous rulings where companies making high margins were excluded.
The two aims of the Special Bench were to determine:
· whether business process outsourcing (BPO) can be compared to knowledge process outsourcing (KPO); and
· whether companies with high profit margins should be included in the list of comparable cases when determining the arm’s-length price (ALP) of an international transaction.
After careful analysis of the TP report submitted by the assessee, the transfer pricing officer (TPO) found six material defects:
1. The taxpayer did not consider current year data in three of 10 comparable companies.
2. The taxpayer used data from two years earlier without justifying the impact the data had on pricing for the taxpayer or comparable companies.
3. The taxpayer considered companies with significant controlled or related party transactions.
4. The taxpayer considered companies with domestic operations when the taxpayer’s Information Technology Enabled Services (ITeS) segment is mainly export oriented.
5. Some of the taxpayer’s comparables do not stand scrutiny of functions, assets and risks (FAR) analysis.
6. Companies such as Eclerx Services were not selected even though it carries out KPO services and qualifies to all filters applied by the taxpayer based on the data pertaining to the 2007 to 2008 fiscal year.
The TPO found the assessee’s benchmark analysis to be unreliable and incorrect, accepting only one of the 13 ITeS comparables selected in the TP documentation. The TPO proceeded to select his own comparables, determining the ALP by the number of relevant international transactions.
The TPO found that the company was operating with more than 2000 employees out of its main facility and was providing support services to its associated enterprises (AEs). According to the TPO, these services constitute KPO services because the assessee was executing logistic-outsourcing services and business analytic services to its AEs, which involved the transfer of knowledge-intensive business, requiring significant domain expertise.
Objections
The assessee filed a number of objections before the Dispute Resolution Panel (DRP). The first was that low-end back office support services had been categorised by the TPO as high-end KPO services. The assessee claimed that the functions during the year under consideration remained the same as last year and, therefore, its categorisation as KPO instead of BPO was incorrect.
The DRP ruled that ITeS cannot be dissected into BPO and KPO services for the purposes of comparability analysis due to the following reasons:
· There are a wide range of activities undertaken in the ITeS sector and therefore a significant overlap between these services.
· Because of the mixed nature of ITeS, the artificial segregation or creation of a third “in-between” category is not possible.
“Availability of data is a major challenge and getting this sort of a detail from public databases is a very difficult task,” said Arun Chhabra from Walker, Chandiok & Co. “This leads taxpayers and tax officers alike, to look at the business description and broad business activity of the comparable from financials and use this information for comparability analysis. This approach would invite intensified scrutiny and challenge after the ruling which requires a very granular comparison to be made. Information such as employee qualification and skill set is generally not available in the database and this would make the task of complying with the dictate of the ruling very challenging.”
The assessee also objected to three comparables selected by the TPO on the basis of their high profitability. The DRP did not find the assessee’s objection sustainable, observing that high and low margins both reflect the industry profitability.
The DRP ruled that:
· Potential comparable companies cannot be excluded on the grounds of abnormally high profits.
· However, abnormal margins should trigger further investigation and analysis to determine whether the high profits are a result of abnormal conditions during the year or whether the abnormal margins indicate that there are different functions being undertaken by these companies.
“The fact that companies with high margins can no longer be excluded is a clear cause for concern for taxpayers and puts a big question mark over realistic expectations for profitability margins when looking at comparables,” said Malhotra.
Before this ruling there was a high degree of confidence that such comparables would be thrown out but now there is a risk that margins as high as 50 to 70% could be included.
How to take advantage of this information
· Amod Khare from BMR Advisors said taxpayers should “re-evaluate the appropriateness of the comparables selected for their TP reports and choose them on the basis of functional comparability” rather than relying on the specific definitions of KPO and BPO.
· Taxpayers must also make sure not to exclude comparable companies on the basis of high profit margins.
