SKP Tax Alert
27 September 2018
Microsoft India (R&D) Pvt Ltd vs DCIT[1] Functional characterization is first step in comparability exercise; role of Indian services provider in Patents registered in group’s name relevant

Facts of the Taxpayer
The taxpayer, resident in India, is a wholly owned subsidiary of Microsoft Ireland Research Ltd with the ultimate parent company, Microsoft Corporation USA (MS USA). The taxpayer is mainly engaged in rendering software development services and information technology enabled services (together referred to as ‘international transactions’) to its Associated Enterprise (AE) viz MS USA. The taxpayer was remunerated on a cost-plus 15% for both the services.

The taxpayer used Transactional Net Margin Method (TNMM) to benchmark the international transactions using external comparable companies. The Transfer Pricing Officer (TPO) concluded that the taxpayer is providing high-end software development services and accordingly rejected almost all the comparable companies of the taxpayer on this ground and also introduced a few new comparable companies. Since the operating margin of comparable companies finally selected by the TPO was higher than that of the taxpayer, the TPO made transfer pricing adjustment for the differential. The dispute resolution panel confirmed the order of the TPO except that it removed one comparable company from TPO’s list which reduced the transfer pricing adjustment marginally.

The detailed facts, arguments of the taxpayer, contention of the TPO and observations of the Tribunal are discussed below:

Provision of Software Development Services
Submissions of the taxpayer
Software development services primarily included two things – contract software development services and internal information technology support. In the entire software product lifecycle, the taxpayer submitted that it provided limited services (writing and testing codes) to AE and that too under their directions.
For major products, services were rendered only for certain functions or modules within the product and not for the whole product, as the same was done by the AE in USA.
For minor products like BizTalk and Data Protection Manager, the taxpayer in India did significant work on product engineering and design work.
Contention of the Transfer Pricing Officer
While examining the said transaction, the Transfer Pricing Officer (TPO) held that the remuneration of cost-plus 15% was not at arm’s length as MS USA earned margin ranging between 60% and 70% based on services rendered by Indian taxpayer. Furthermore, TPO alleged that the Indian taxpayer rendered more than routine software development services, which helped the AE in creating 113 patents, which were registered in the USA. The TPO further alleged that even though the overall work was to be supervised by the AE, the work done by the taxpayer was to be done by its own team of experts having 1,376 persons. TPO concluded that the software development services rendered were high end in nature and resulted in the creation of intangibles which are distinct from a routine software developer.
Accordingly, TPO retained only one company from the taxpayer set and chose three new companies for the purpose of benchmarking analysis. Working Capital Adjustment claimed by the taxpayer was disallowed by the TPO with the view that such an adjustment cannot be made as a matter of practice and routine. Thus an adjustment of INR 1,972.40 million was made after Dispute Resolution Panel (DRP) granted a minor relief.
Aggrieved by this, the taxpayer filed an appeal before the Income Tax Appellate Tribunal (ITAT). We have briefly summarized the ITAT’s observations and judgment on each of the critical grounds/submissions/justifications made by the taxpayer:
ITAT observations and judgment
  1. Functional profile of the taxpayer
    The primary contention of the taxpayer being inclusion of all companies from its own benchmarking set and exclusion of certain companies selected by the TPO, the ITAT held that comparability of companies could be gauged only after fully ascertaining the functional profile of the taxpayer. Based thereon, the ITAT analyzed the submissions and the documents that were placed before them. The same are tabulated below:
    Sr. No. Submission/Documents analyzed Observation/Comments of ITAT
    • Transfer pricing  documentation; and
    • Interviews of certain employees conducted by the Advance Pricing Agreement (APA) authorities
    • The ITAT held that statements of the taxpayer in the APA submissions were inconclusive as no decision of the APA has come so far.
    • The taxpayer failed to submit any material/evidence to justify the nature of work, a limited role played by it while providing these services and only harped on the interviews conducted by the APA authorities.
    • Parent-Subsidiary Agreement (PSA) between MS USA and the taxpayer; and
    • Amended and restated PSA on 1 January 2009 with retrospective effect from 1 July 2003
    • Admittedly (during APA interview) the taxpayer maintained all primary records relating to workflow but did not produce the same before the authorities in spite of requests and simply doing lip service, trying to marginalize its role to a bare minimum.
    • Based on a few clauses that were amended in PSA dated 1 January 2009, it was observed that the work to be performed would not only be confined to developing code, but also otherwise completing the project assigned to it by MS USA, which was contrary to the claims made by the taxpayer.
    • PSA and amended restated PSA clearly indicate that the nature of work done by the taxpayer is that of Research and Development (R&D) in the overall Microsoft products albeit to a limited extent.
    Sample copies of Patents registered in the USA
    • The fact that 113 patentable inventions were done by taxpayer in India by its software development work that got registered in the USA leaves no room for doubt that it is undoubtedly engaged in research activities and is significantly different from a routine software developer.
    • Even though integration of all the software developed in several countries is done in the USA that does not mean that the research work done by the taxpayer or for that matter by AEs in the other countries, ceases to be a research work in itself.
    • Though taxpayer cannot be categorized as a full-time software developer, but with its limited involvement and within the scope of work assigned, it is undertaking R&D and creating intangibles, which are even patented.
    Letter dated 12 January 2015 submitted by the taxpayer before the TPO It was observed that the taxpayer admitted that it continues to be a development center undertaking contract R&D activity with insignificant risk.

    Additionally, the ITAT also analyzed the functions of a taxpayer in light of Central Board of Direct Taxes (CBDT) Circular No. 6 dated 29 June 2013 on “functional profile of development centers engaged in contract R&D services with insignificant risk-conditions relevant to identify such development centers.” The observations of the ITAT in this regard are tabulated below:
    Sr. No. Condition as laid down in Circular No. 6/2013 ITAT Observations
    Foreign Principal Indian Development Centre (IDC) AE (as Foreign Principal) Taxpayer (IDC)
    1 Performs economically significant functions (conceptualization, the design of the product, provide strategic direction and framework) Carries out work assigned by the Foreign Principal. Yes Yes
    • Provides economically significant assets (capital/funds, intangibles) for carrying out research and product development work
    • Remunerates the IDC for work done.
    • Yes
    • Yes – Cost plus 15%
    3 Control or supervise research or product development by  strategic decisions to perform core functions as well as monitor activities on a  regular basis Works under the direct supervision of the foreign principal Yes Yes
    4 - Conduct shows that no economically significant realized risks are borne by it - Yes
    5 If it is located in low or no tax jurisdiction; assumed that it does not control risk unless proved otherwise by IDC - Not applicable, as AE not located in low/no tax jurisdiction -
    6 Retains ownership right, which is evident from the contract as well as the conduct of foreign principal No ownership right (legal or economic) on the outcome of the research Yes Yes

    Based on the aforesaid observations the ITAT concluded that the taxpayer is a contract R&D service provider.
  1. Comparable Companies for benchmarking software development services
    Basis the above findings on functional characterization of the taxpayer, the ITAT suggested following parameters for selection of comparable companies for benchmarking purposes in the instant case:
    • Comparable company should have income from R&D activities.
    • Appropriate segmental information should be available if the company earns income from software services as well as products.
    • Companies spending on R&D activities wholly for its internal use cannot be compared.
    • Persistent loss-making segment/company, cannot be considered as a comparable.
    • Simply because a company was wrongly considered by the taxpayer as comparable, it cannot act as a deterrent from challenging before the ITAT.
    Considering all the above findings, the ITAT remitted the matter to the file of the TPO for fresh determination of their Arm’s Length Price (ALP) based on above guidance. 
Provision of information technology enabled services
Contention of the Transfer Pricing Officer
The modus operandi of the TPO to determine the ALP of information technology enabled services transactions was similar to that of software development services viz removing comparable companies of a taxpayer and introducing new comparable companies. DRP confirmed the transfer pricing adjustment.
ITAT observations and judgment
  1. Functional profile of the taxpayer
    Under the ITES Segment, taxpayer was engaged in resolving technical problems in respect of complaints received from the customers of Microsoft. On perusal of the submissions, the ITAT was of the view that unlike software development services, there is no conflict in the nature of services rendered by the taxpayer under this segment, i.e. ITeS services.
  2. Comparable companies for benchmarking ITeS
    The ITAT suggested following parameters for selection of comparable companies for benchmarking of ITeS services in the instant case:
    • The services rendered under this segment cannot be compared to companies earning revenue from Knowledge Process Outsourcing (KPO) operations, software services.
    • Segmental information should be available if the company earns income from services as well as products.
    • Persistent loss-making segment/company cannot be considered as a comparable.
    • If the company having different financial year ending is functionally comparable and relevant data for the concerned financial year can be deduced from the information available from its Annual reports, then, there can be no objection to the inclusion of the relevant segment of the company in the list of comparables with the adjusted data.
    • The company having high or low turnover can be no reason to justify its exclusion if it is otherwise functionally comparable.
    Considering all the above findings, the ITAT remitted the matter to the file of the TPO for a fresh determination of their ALP.
[1] ITA No. 1479/Del/2016 and ITA No. 691/Del/2016
SKP's Comments
Be it Google, McKinsey and now Microsoft, the Indian tax authorities are increasingly focusing on functional profile and economic characterization of Indian service providers for determining the comparability and ALP. This is a significant shift from the historical approach of majorly deciding the case basis the legal arguments of the appellants. The tax authorities seems to have picked-up relevant aspects from BEPS Action Plan 8 to 10 – aligning transfer pricing outcomes to value creation - whether it is disregarding of contractual terms and giving importance to actual conduct or assessing the value creation in the entire supply chain.
In the above-referred case of Microsoft, the ITAT also factored the role of Indian taxpayer in 100+ patents registered in the USA for determining the economic characterization. This will perhaps trigger fresh approach on part of the field level tax authorities in analyzing the role of Indian taxpayers in patents registered in the name of overseas AE.
Transfer pricing analysis is a two-sided analysis of the functional profile of both the taxpayer and its AEs. Multinational Enterprises having Indian development centers should reassess their functional profile and transfer pricing policy in light of the above ruling. It would be extremely difficult for the taxpayers who have carried out one-sided analysis and are just trying to marginalize its role to a support service provider to justify its transactions at ALP, unless they are backed by robust documentation.

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