S.92C:Avoidance of tax-Transfer Pricing: Important principles on “turnover filter” & comparison
explained.
The Tribunal had to consider the following important transfer pricing issues: (i) whether a one-time and
extraordinary item of expenditure (ESOP cost) debited to the assessee’s P&L A/c has to be excluded
while comparing the margins, (ii) whether for the purpose of comparison of margins, the consolidated
results of comparables having profit from different overseas markets can be considered? (iii) whether
extreme profit and loss cases should be excluded or in case extreme profit cases are included, the case of
losses should also be included? (iv) whether a turnover filter can be adopted to exclude companies with
extremely high turnover? (v) whether the assessee can seek to exclude its own comparables? (vi) whether
an adjustment for working capital is permissible? (vii) whether if the assessee can show that because the
AE is in a high tax jurisdiction and that there is no transfer of profit to a low tax jurisdiction, a transfer
pricing adjustment need not be made? HELD by the Tribunal:
(i) A comparison of margin between the assessee and the comparables has to be made under identical
conditions. As the comparables had not claimed any extraordinary item of expenditure on account of
ESOP cost, for the purpose of making proper comparison of the margin, onetime ESOP cost incurred
by the assessee has to be excluded. There is nothing in the Rules that prohibits adjustment in the margin
of the assessee to remove impact of any extraordinary factors (Skoda Auto India(P) Ltd. v. ACIT (2009)
30 SOT 319 (Pune), Demag Cranes & Components (India) (P) Ltd. (2012) 49 SOT 610 (Pune),
Transwitch, Toyota Kirloskar Motors followed);
(ii) Under Rule 10B(2) (d), the comparability of transactions has to be considered after taking into
account the prevailing market conditions including geographical locations, size of market and cost of
capital and labour etc. Therefore, consolidated results which include profit from different overseas
jurisdictions having different geographical and marketing conditions will not be comparable. Only
standalone results should be adopted for the purpose of comparison of margins (American Express
followed);
(iii) Comparable cases cannot be rejected only on the ground of extremely high profit or loss. In case
the companies satisfy the comparability criteria, and do not involve any abnormal business conditions,
the same cannot be rejected only on the ground of loss or high profit. The OECD guidelines also
provide that loss making uncontrolled transactions should be further investigated and it should be
rejected only when the loss does not reflect the normal business conditions;
(iva) In certain Tribunal decisions, various reasons have been given for applying the turnover filter for
comparison of margins such as economy of scale, greater bargaining power, more skilled employees and
higher risk taking capabilities in cases of high turnover companies, which increase the margins with rise
in turnover. However, in these decisions, no detailed examination has been made as to how these factors
increase the profitability with rising turnover. The concept of economy of scale is relevant to
manufacturing concerns, which have high fixed assets and, therefore, with the rise in volume, cost per
unit of the product decreases, which is the reason of increase in margin as scale of operations goes up
because with the same fixed cost there is more output when the turnover is high. The same is not true in
case of service companies, which do not require high fixed assets. In these cases employees are the main
assets, who in the case of the assessee are software engineers, who are recruited from project to project
depending upon the requirement. The revenue in these cases is directly related to manpower utilized.
With rise in volume cost goes up proportionately. Therefore, the concept of economy of scale cannot be
applied to service oriented companies. On facts, it is shown by the department that in the case of the
comparables selected by the assessee, there is no linear relationship between margin and turnover and
that that the margin has come down with the rise in turnover in some cases. Such detailed study was not
available before the various Benches of the Tribunal which have applied the turnover filter and
consequently those decisions cannot be followed;
(ivb) Under Rule 10B(2), comparability of international transactions with uncontrolled transactions has
to be judged with reference to functions performed, asset employed and risk assumed. The functions
performed by all comparable companies are same as it is because of same functions they have been
selected by the assessee as comparables. The asset employed has two dimensions i.e. quantity and
quality. More employees would mean more turnover, but there is no linear relationship between margin
and turnover. As regards quality of employees, this will depend upon the nature of projects and since
the comparables are operating in the same field having similar nature of work, and employee cost being
more in case of more skilled manpower, it will not have much impact on the margins. As for the
bargaining power, the assessee is part of a multinational group and well established in the field and,
therefore, it cannot be accepted that it has less bargaining power than any of the Indian Companies,
however big it may be. Therefore, it would not be appropriate to apply turnover filter for the purpose of
comparison of margins. However, for the purpose of comparison, the turnover would be relevant only
from the limited purpose to ensure that the comparable selected is an established player capable of
executing all types of work relating to software development as the assessee is also an established
company in the field (Genesis Integrating Systemnot followed);
(v) The assessee had selected Infosys and Wipro as comparables on the basis of its own transfer pricing
study after being fully aware of its work profile. The assessee raised no plea either before the TPO or
DRP for excluding these comparables though it had added some more comparables. The assessee,
therefore, cannot raise any grievance before the Tribunal to exclude these comparables, without giving
any cogent and convincing reason. The reasons given by the assessee (turnover filter) are not found
convincing and so it cannot be permitted to exclude Infosys and Wipro (Kansai Nerolac Paint followed)
(vi) Working capital adjustments are required to be made because these do impact the profitability of the
company. Rule 10B(2) (d) also provides that the comparability has to be judged with respect to various
factors including the market conditions, geographical conditions, cost of labour and capital in the
market. Accounts receivable/payable effect the cost of working capital. A company which has a
substantial amount blocked with the debtors for a long period cannot be fully comparable to the case
which is able to recover the debt promptly. The average of opening and closing balance in the account
receivable/payable for the relevant year may be adopted which may broadly give the representative level
of working capital over the year. Even if there is some difference with respect to the representative
level, it will not affect the comparability as the same method will be applied to all cases. Working capital
adjustment cannot be denied to the assessee only on the ground that the assessee had not made any
claim in the TP study if it is possible to make such adjustment. Working capital adjustment will improve
the comparability.
(vii) The argument that no adjustment need be made because the parent company is situated in US where
tax rate is high and that there was no reason for the assessee to transfer profit to the parent company is
not acceptable. The arm’s length price of an international transaction has to be calculated with respect
to similar transaction with an unrelated party as per the method prescribed and the revenue is not
required to prove tax avoidance due to transfer of profit to lower tax jurisdiction. Arguments such as
that the parent company was incurring loss or had shown lower margin are not relevant (Aztek Software
& Technology Service Ltd. v. A CIT (2007)107 ITD 141 (SB) &24/7 Customers.com followed) (A. Y.
2007-08)
No comments:
Post a Comment