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Transfer pricing decision on captive software development entity

The Income Tax Appellate Tribunal (ITAT) delivered a ruling dated 10 June 2008 in the case of E-Gain Communication Pvt. Ltd. v. Income Tax Officer (2008-TIOL-282-ITAT-PUNE) on the issue of whether an Indian software company providing services to its US parent at cost-plus 5% was appropriate under the Indian transfer pricing regulations.

(a) Facts. The Taxpayer (i.e. E-Gain Communication Pvt. Ltd.) was engaged in the business of software product development. It was a "100% Export Oriented Unit" approved by Software Technology Park of India (STPI). The Taxpayer had also claimed a tax exemption under Sec. 10A of the Income Tax Act 1961 (ITA). In the course of the benchmarking analysis, the transfer pricing officer (TPO) compared the net cost-plus mark-up of 5.16% earned by the Taxpayer against the weighted average net cost-plus of 16.12% earned by the set of 20 comparable companies selected by the TPO.

The TPO issued a notice to the Taxpayer requiring explanation as to why no adjustments were made to its 5% cost-plus mark-up, in comparison to the financial results of other comparable companies in the market. The Taxpayer submitted a response containing the following points:

-   the income received from the US parent represents assured income. As such, the cost-plus 5% mark-up has remained as the consideration for the provision of services to its parent company; and
-   it earns a healthy gross profit margin of 31.92% and its operations with associated enterprises in the US constituted only 11.26% of its total business.

The TPO, dissatisfied with the response from the Taxpayer, made an upward revision in the cost-plus mark-up disclosed by the taxpayer. On appeal, the Commissioner of Income Tax (Appeals) [CIT(A)] upheld the order of the TPO.

(b) Issue.The key issue before the ITAT was whether the TPO was justified in making the upward adjustment to the profit margin disclosed by the Taxpayer on its transactions with its US parent.

(c) Decision.The ITAT held that no adjustment was warranted under the Indian transfer pricing regulations, and hence, the upward adjustment made to the net profit margin by the TPO was not legally valid.

The ITAT observed that the Taxpayer was a captive company rendering services of software development to its parent company. In accordance with the agreement between the Taxpayer and its parent company, the Taxpayer was to be remunerated a cost-plus 5% for software developed and supplied to the parent company. Although there was no dispute between the authorities and taxpayer on the use of the Transactional Net Margin Method (TNMM) as the method of computing the arm's length price (ALP), the area of difference was primarily in the comparables selected by the TPO for the purposes of deriving the average profit margin of the comparable companies, without adjustments being made to account for the differences in the comparables.

The ITAT observed that for the purposes of comparing transactions or enterprises using the TNMM, differences which are likely to materially affect the price, cost charged or paid, or profits in the open market should be taken into consideration for the purposes of making reasonable and necessary adjustments to eliminate the differences which may have material effects on the transaction. If the differences are such that they cannot be evaluated, the transaction may then have to be eliminated from the comparability study. As transfer pricing requires the adjustment of differences between international transactions and the comparable uncontrolled transactions, the application of the TNMM similarly requires that suitable adjustments be made for differences based on the functions, assets and risks (FAR) analysis and other relevant factors. The Indian transfer pricing regulations require that if there are material differences, those differences are to be considered and suitable adjustments should be made. The tax authorities were in error for not making those adjustments.

The ITAT further observed that the TPO has erred in his conclusion that it was not necessary to perform functional and other analyses to ascertain the differences in transactions due to the fact that the TNMM was more tolerant of minor functional differences, and his reliance on the OECD Transfer Pricing Guidelines (the OECD Guidelines) of July 1995 (paragraph 3.2.7) was out of context. The strength and weaknesses of the TNMM are compared to the other methods in the OECD Guidelines, and in this case, the TPO had overemphasized a particular positive point of the TNMM.

It was held by the ITAT that the comparison of controlled and uncontrolled transactions under the TNMM should entail that differences which have a tangible bearing on costs, prices or profits are to be accorded its proper weightage in order for reasonable adjustments to be made to eliminate such differences. The tax authorities should endeavor to perform robust and comprehensive FAR analyses for the selection of comparable companies, and if necessary, adjustments should be made to the operating profits of comparable companies.

Referring to the OECD Guidelines, the ITAT quoted the following paragraph which dealt with the inherent weakness of the TNMM method:

"There are also a number of weaknesses to the transactional net margin method. Perhaps the greatest weakness is that the net margin of a taxpayer can be influenced by some factors that either do not have an effect, or have a less substantial or direct effect, on price or gross margins. These aspects make accurate and reliable determinations of arm's length net margins difficult. Thus, it is important to provide some detailed guidance on establishing comparability for the transactional net margin method."

The ITAT held that even when TNMM method is applied to determine the ALP in accordance with the OECD Guidelines, the FAR assumed both in the controlled and uncontrolled transaction should be taken into account. Also, it is not permissible to ignore specific Indian regulations on the subject of transfer pricing.

The ITAT noted that the transfer pricing regulations of the US provided for necessary adjustments for differences in the application of methods similar to TNMM, and further noted that both the OECD Guidelines and the US Transfer Pricing Regulations, in fact, required the necessary adjustments be made for differences affecting profitability. According to the ITAT, the TNMM method affords practical solutions to otherwise insoluble transfer pricing problems, if used sensibly and with appropriate adjustments to account for the differences in the various types of scenarios.

The ITAT held that CIT(A) was justified in selecting comparable companies which registered a turnover between INR 50 million to INR 250 million, but the consideration of turnover was not the only relevant factor in a transfer pricing analysis. There were other material factors which had to be taken into account which affect the profitability of a company based on the FAR analysis, which had to be performed. Since this exercise was not performed, the ITAT concluded that the comparison made by the TPO was improper and hence illegal.

The ITAT also observed that while it did not agree with the Taxpayer's argument that only entities which met a certain turnover criteria could be considered as a comparable company for the ALP evaluation, and similarly, it did not see the TPO's justification for the consideration of "oversized" entities.

The Taxpayer produced evidence to demonstrate that two comparable companies selected by the TPO in his analysis had other income such as interest from deposits, dividend income and income from the sale of licenses, which increased its profit margin. Other income cannot be included for the purpose of the comparability when the tested party is solely carrying on a business of software development. If it was not possible to compute and exclude receipts and expenditures from the categories of income which did not relate to the software development business, such companies should have been excluded as comparable companies. The ITAT also held that the adjustments to the profit margin was required in the case of the Taxpayer as it did not undertake any risk in the transactions with its parent company.

Accordingly, the ITAT allowed the appeal and removed the additional taxable income levied on the Taxpayer resulting from the upward adjustments to the ALP in its dealings with the US parent company.

Decision on computation of ALP and other transfer pricing matters

The Income Tax Appellate Tribunal (ITAT) delivered a ruling dated 22 January 2008 in the case of Ranbaxy Laboratories Ltd. v. Additional Commissioner of Income Tax, New Delhi ([2008] 110 ITD 428 (DELHI)), ruling that the tax authority/assessing officer (AO):

-   failed to properly examine the characteristics of the transactions;
-   allowed the taxpayer to improperly use its overseas associated enterprises (OAEs) as the "testing party" in its transfer pricing calculations;
-   did not require adequate documentation; and
    failed to refer the case to a special transfer pricing officer (TPO) as required.


The Taxpayer (i.e. Ranbaxy Laboratories Ltd.) is an Indian multinational company that is in the business of manufacturing and selling of pharmaceutical products. During the relevant financial year, the Taxpayer had entered into certain international transactions relating to its business, i.e. transfer of goods and services with its OAEs spread over a number of countries. The Taxpayer's operations, amongst others, included complex research and development, manufacturing and quality control, while the OAEs primarily were primarily involved in sales, distribution and secondary manufacturing activities. The Taxpayer selected its OAEs as testing parties as they were involved in less complex functions, assumed less risks, and did not own valuable intangibles. To demonstrate the arm's length nature of the international transactions, the Transactional Net Margin Method (TNMM) was adopted as the most appropriate method and for this purpose, a single set of comparables from various countries was used to benchmark the aggregate international transactions of the Taxpayer.

The AO, without referring the arm's length price (ALP) determination to the TPO, held that the prices between the Taxpayer and the OAEs were at an arm's length. It should be noted that the Central Board of Direct Taxes (CBDT) had issued an instruction, i.e. Instruction No. 3 of 2003, requiring cases to be referred by the AO to the TPO for determination of ALP, where the aggregate value of all international transactions of a taxpayer is in excess of INR 50 million. The aggregate value of the transactions in the Taxpayer's case exceeded INR 50 million.

However, the Commissioner of Income Tax (CIT) initiated action under Section 263 of the Indian Income Tax Act 1961 (ITA), which confers revisionary power on the CIT, on the basis that the tax assessment was "erroneous and prejudicial" to the interests of the tax authority. The primary objections raised by CIT were as follows:

-   the issue of determination of the arm's length principle was not referred to the TPO as required by the CBDT Instruction;
-   the Taxpayer should have been selected as the testing party; and
-   the method employed by the Taxpayer to determine the ALP was incorrect, i.e. the aggregation of all the OAEs and deeming them as a single testing party was not in accordance to the Income Tax Rules 1962 (IT Rules).


The key issues before the ITAT were whether or no the case should have been referred by the AO to the TPO, and if the method sued to compute the ALP and choose the comparables were in order.


The ITAT found that the assessment order passed by the AO was erroneous for a number of reasons, as discussed below.

(a) Referral of the case to the TPO. The ITAT found that the AO had erred in not referring a case where the international transactions were in excess of INR 50 million to the TPO. The AO was mandatorily required to make the reference to the TPO pursuant to the Instruction issued by the CBDT.

(b) Selection of the testing party. The ITAT observed that the choice of testing party is contingent upon level of complexity of the transacting entities based on functions performed, assets used, and risks assumed (FAR) analysis of the relevant entity and availability of reliable data. The ITAT also found that both the US regulations and the OECD Transfer Pricing Guidelines emphasize that the testing party should be such that the ALP could be verified using the most reliable data.

When determining the choice of testing party, the complexity of transacting entities was only one factor to be considered and another equally important factor was the availability and reliability of data. Therefore, where OAEs are chosen as the testing party, the relevant data should either be available in public domain or furnished to the tax authorities for validation of the ALPs.

The ITAT held that the transfer pricing documentation, provided by the Taxpayer to the tax authorities did not cover the basic details of international transactions such as description, quantity and volume of the goods transferred. No computations for margins of identified comparables and testing party were provided. Similarly, no details were furnished in respect of business profile, composition of total cost and turnover for the OAEs. Accordingly, the OAEs could not be accepted as the testing party since the criterion of data availability was not met.

(c) Aggregation of the transactions. The ITAT noted that the Taxpayer lumped together the OAEs and compared their mean profit margin with the mean profit margin of all comparable companies. The aggregation was done pursuant to Rule 10A(d) of the ITR under which "transaction" includes "number of closely linked transactions". The ITAT laid down the following principles with regard to the aggregation of transactions:

-   Based on the OECD Transfer Pricing Guidelines, "the ideal situation of comparing was transaction by transaction basis" but the grouping of transactions was justifiable if the transactions could not be evaluated adequately on a case-by-case basis; and
-   The ITAT rejected the Taxpayer's approach because: (i) the OAEs with which transactions had been entered into were based in different countries. Additionally, the different geographical locations of the OAEs resulted in different market conditions and economic realities as evidenced by the different levels of profitability of the OAEs. Therefore, the profitability of entities subject to different market/economic conditions should not be agggregated; (ii) the transactions with these OAEs did not just include the sale of pharmaceutical products but also involved cost-sharing, the transfer of know-how and technology, etc.; (iii) the operating margins of the OAEs varied substantially (ranging from minus 42.17% to 11.22%); and (iv) the Taxpayer did not to demonstrate the "closely linked" nature of the different transactions and so the aggregation approach should not be accepted.

(d) Inadequate data in the Accountant's Certificate. The ITAT held that the AO should have rejected the statutory certification (i.e. Form 3CEB) as being non-compliant since it did not contain adequate details on the OAEs or transactions undertaken (e.g. type and quantity of goods transferred, specific characteristics of the goods) as was required in order to examine the accuracy of the transfer prices.

(e) TNMM – Use of FAR analysis. The Taxpayer, relying on the OECD Transfer Pricing Guidelines, argued that details of individual transactions with the OAEs were not relevant when applying the TNMM to calculate the ALP. The ITAT reaffirmed the observations in the Mentor Graphics case that a FAR analysis was required even while applying the TNMM.

(f) Availability of internal comparable uncontrolled prices. The ITAT held that since the Taxpayer had undertaken similar transactions with independent parties, the AO:

-   should have, pursuant to Rule 10B(2)(c) of the ITR, examined the contractual terms in order to determine the extent to which the difference in risk profile affected the prices (Note the Taxpayer had contended that the transactions could not be used for the purposes of benchmarking due to the difference in risk profiles); and
-   should have explored the possibility of being able to make appropriate adjustments for the differences in risk profile.

(g) Analysis of the comparable entities and adjustment in the respective prices. The ITAT ruled that for the purpose of benchmarking, the nature and character of the products or services would have to be considered prior to a FAR analysis. The ITAT observed that the Taxpayer's transfer pricing documentation failed to provide information on character of the products transferred and therefore, the comparability analysis could not be accepted as accurate.

The geographical region was also an important factor to be taken into account when benchmarking and the Taxpayer who had transferred goods/services to its OAEs located in different geographical locations had chosen comparables from countries where the OAEs (i.e. the testing parties) were not located. As such, the ITAT found the Taxpayer's analysis to be defective.

The ITAT reiterated the importance of making comparability adjustments wherever required based on the earlier decisions in the Aztec Software & Technology and Mentor Graphics cases.

Ruling on whether foreign company entitled to lower rate of tax on long-term capital gains

The Indian Authority for Advance Rulings (AAR) delivered a ruling dated 28 February 2008, in the case of McLeod Russel Kolkata Ltd. that a foreign company would also be entitled to the lower/concessional tax rate of 10% on long-term capital gains, earned on the sale/transfer (both terms used inter-changeably) of shares of an Indian Company.

(a) Facts. Moran Holding PLC, a non-resident UK-based company had sold shares in an Indian Company to the Applicant, McLeod Russel India Ltd. The capital gain arising on such disposition of shares was taxable in India (Note. Capital gains are termed as long-term if they arise from shares, which were held for a period of more than 12 months prior to their transfer). The Applicant filed an application for an advance ruling as regards the rate of tax to be applied to such long-term capital gains.

Under the proviso to Sec. 112 of the Indian Income Tax Act 1961 (ITA), long-term capital gains would be chargeable to tax at the lower tax rate of 10% (as against normal rate of 20%) if the tax exceeds 10% of the amount of the capital gains before giving effect to the provisions of the ITA that deal with the "indexation" of the cost of acquisition of capital assets.

The tax authorities argued that Sec. 112 of the ITA makes a distinction between an Indian resident company and a non-resident foreign company and provides for tax rate of 20% for foreign companies. Therefore, a foreign company is not entitled to the benefit of the lower rate of 10% since they are not entitled to the benefit of indexation of the cost of acquisition of shares, etc.

The relevant statutory provisions are:

-   Mode of computation of capital gains.

Sec. 48 of the ITA deals with the method of computation of taxable capital gains. It provides that capital gains are to be computed by reducing from the "full value of consideration" received for the transfer of a capital asset (shares in this case), its "cost of acquisition" (COA). In case the capital asset is a long-term capital asset, the COA is to be substituted by its indexed cost of acquisition by increasing the COA proportionately with the "cost inflation index" published by the government for the relevant year.

The proviso to Sec. 48 of the ITA states that in the case of a taxpayer who is a non-resident, capital gains from the transfer of shares of an Indian company shall be computed by converting (i) the COA, (ii) expenditure incurred wholly and exclusively in connection with such transfer, and (iii) the full value of the consideration received or accruing as a result of the transfer of shares, into the same foreign currency as was initially utilized in the purchase of the shares. The capital gains so computed in such foreign currency shall be converted back into the equivalent INR amount.

Thus, a non-resident (including a foreign company) is not eligible for the benefit of indexation if the investment was made in foreign currency.

-   Rate of tax on long-term capital gains.

Sec. 112 of the ITA provides the rates of tax applicable for long-term capital gains. Such gains are taxable in India at the rate of 20%. However, Sec. 112 provides that capital gains can be taxed at the rate of 10%, if the benefit of indexation is not taken.

The Applicant argued that even though the investment in the shares of the Indian company was made in foreign currency and that it was not entitled to the benefit of indexation of the COA, it was still eligible for the lower rate of tax rate of 10% on its long-term capital gains.

(b) Issue. The key issue before the AAR was whether the Applicant, which was a non-resident in India, was eligible for a lower rate of tax of 10% on long-term capital gains arising in India on the sale of shares in an Indian Company.

(c) Decision. The AAR held that a foreign company was also entitled to the lower tax rate of 10% on long-term capital gains earned on disposition of shares of an Indian company.

The AAR observed that the proviso to Sec. 112(1) of the ITA was a special provision concerning the transfer of certain long-term capital assets (i.e. listed shares and securities, units, etc.), and there was no justification to limit the lower rate of 10% provided therein only to resident companies.

The AAR also held that the eligibility to avail of the benefit of the "indexed cost of acquisition" was not a sine qua non or a pre-condition for applying the lower rate of 10% provided in Sec. 112 of the ITA. The indexation formula does not enter into the picture for computing the quantum of capital gains in the case of a non-resident foreign company. But that does not mean that Sec. 112 requires denial of this lower tax rate of 10% to foreign companies.

The AAR concluded that no distinction could be made between an Indian resident company and a foreign company for applying the lower rate of 10% to long-term capital gains on sale of shares of an Indian company.

Note. A similar ruling was made by the AAR in the case of Timken France SAS (2007) 294 ITR 513 (AAR) wherein also it was held that the lower rate of capital gains tax rate was also applicable to a foreign company earning long-term capital gains from sale of shares of Indian companies.

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