Cost allocations – Between tax free and taxable units – Domestic Transfer Pricing

    Tax holiday undertakings are required to maintain separate books of account and get them audited. In respect of direct costs of such undertakings there is no issue. Whereas assessee at the entity level maintaining both tax holiday undertaking and non-tax holiday undertaking incurs common expenditure which may be chiefly called as "HO Expenditure" such as general administrative expenses like travelling, conveyance, communication, marketing, legal and professional expenses, etc. In respect of such expenditure a proper allocation must be made among all the undertakings of the assessee. This is where, how an allocation is made to a tax holiday undertaking is a subject matter for domestic transfer pricing provisions. In other words, whether the allocation made is complying with the arm’s length standard is to be examined by the domestic transfer pricing provisions.

    Common expenses have to be allocated among the undertakings on the basis of say turnover, number of employees, etc. Certain expenses like finance costs and human resource costs which do not directly relate to any eligible undertaking, cannot be apportioned in an easy manner. However the corporate office or the head office exists for the sake of various business activities carried on by different units of the assessee. Therefore even finance and HR costs have to be allocated to all the undertakings. In this context, Bangalore Bench of the ITAT in the case of Wipro Information Technology v. DCIT (2004) 88 TTJ (Bang.) 778 held that the corporate group does not carry on any business activity by itself and hence cannot be called to be the business of the tax payer. The expenditure incurred by the corporate office cannot be related to any undertaking and accordingly it was held that interest on funds borrowed for the purpose of the corporate office need not be apportioned to any of the tax holiday undertakings for the purpose of computing tax holiday profit. Similar view has been taken by the Hon’ble Bombay High Court in the case of Zandu Pharmaceuticals Works Ltd., v. CIT (2013) 213 Taxman 207.

    7.1 Whether every cost allocation should have a markup is a matter of debate in the context of domestic transfer pricing provisions.

    It is to be examined whether a particular cost allocation is a service by itself by one undertaking to the other. If so, the same must be marked up. In the OECD TP guidelines we have some guidance in the context of intra group services. If the service is more of a group management cost to enhance the image of the group and to ensure quality in services / products which is apportioned among the group companies then such apportionment should be on cost to cost basis and there should not be any markup. The same concept applies even in the context of intra-undertaking allocation of costs relating to group management. Sometimes a service is different from what is explained above and may be compared with any marketable service availed from a third party. In other words, a service availed from a group company is to be paid with a markup as such service if availed from a third party would also have been paid like a marketable service. Same concept would apply to marketable services rendered by one undertaking to the other when one of such undertakings is a tax holiday undertaking.