Volume 5, Issue 25

10th October, 2012

Tax Alert
Tribunal takes a close look at FAR Analysis, Intangibles and Location Savings


Within the realms of transfer pricing, FAR (Functions performed, Assets owned and Risks assumed by the associated enterprises (“AEs”) involved) plays a critical role in determining the arm’s length price of an international transaction entered into between AEs. The FAR analysis defines roles, responsibilities and risks assumed by the parties involved providing steadfast pointers into the underlying economic substance of the transactions. Even the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations recognise the importance of FAR in the transfer pricing context, with the arm’s length compensation between AEs reflecting the functions that each enterprise performs (taking into account the assets used and the risks assumed by either party).

Significance of a detailed FAR analysis came to the fore in a recent ruling of Delhi Income Tax Appellate Tribunal (the “Tribunal”) in the case of GAP International Sourcing (India) Pvt. Ltd. (“GAP India” or “Taxpayer”). The ruling also carries pertinent remarks on topics such as intangibles and location savings. The case is discussed hereunder along with the takeaways embedded therein.

Facts of the case

The taxpayer is a wholly owned subsidiary of GAP International Sourcing Inc., USA (“GAP USA”). The taxpayer is engaged in the business of facilitating sourcing of apparel merchandise from India on behalf of the GAP Group companies as per the schedule supplied by GAP USA. For rendering the above mentioned services, the taxpayer is remunerated at full cost plus 15%. The taxpayer, based on its FAR profile, characterized itself as a limited risk bearing support service provider. The taxpayer applied the transactional net margin method (“TNMM”) to benchmark its international transactions and concluded a remuneration of cost plus 15% to be at arm’s length.

TPO & DRP Observations

During the transfer pricing audit proceedings, the transfer pricing officer (“TPO”) disregarded the taxpayer’s FAR sketch and characterization, and held the cost plus remuneration to be inappropriate. The TPO contended that the functions performed by the taxpayer were extremely critical and even a minuscule error could adversely impact the group operations. It was alleged that the taxpayer had created substantial intangibles in terms of supply chain management such as vendor lists, sampling procedure, quality control standards, logistics, among others. Further, the TPO held that a well-organized workforce employed by the taxpayer had led to creation of valuable human intangibles. Additionally, the TPO stated that location savings in the form of lower raw material cost that was created by the taxpayer on account of operating in a low cost economy had not been factored into the cost plus model.

Relying on the ruling of the Tribunal in the case of Li and Fung India Pvt. Ltd and an out of court settlement between the US tax authorities and Tommy Hilfiger, the TPO proposed a commission based model to adequately compensate the taxpayer for its FAR and also factor in the location savings generated. The TPO further held a commission of 5% on the FOB value of goods sourced by the AE through Indian vendors as arm’s length. Accordingly, large adjustments were made to the taxpayer’s income that resulted in imputed returns on operating expenses to the extent of 830% and 660% for FY 2005-06 and FY 2006-07 respectively. Against this, the taxpayer approached the Dispute Resolution Panel (“DRP”) with its arguments. However, the DRP upheld the TPO’s order. Aggrieved, the taxpayer filed an appeal with the Tribunal.

Tribunal’s Ruling

Based on the detailed submissions made by the taxpayer in support of its FAR profile, the Tribunal characterized the taxpayer as a low risk procurement support service provider entitled to a cost-plus remuneration as against a commission based remuneration proposed by the Revenue. While distinguishing the case of the taxpayer from that of Li and Fung India Pvt. Ltd, the Tribunal has also put forward key observations on the significance of FAR, development of intangibles and location savings. The arguments of the taxpayer and the Tribunal’s comments are discussed topically hereunder.

FAR Investigation

The Revenue’s contention that the taxpayer had borne significant business risks lacked substantiation. Based on the facts, the Tribunal concluded that the taxpayer’s role, functions and activities were limited merely to following the instructions given by GAP USA. This clearly indicated that the taxpayer lacked the decision-making authority and thereby the capability to bear significant risks such as market risk, credit risk, product liability risk, among others.

Human Intangibles

The Tribunal accepted the taxpayer’s contention that the workforce employed by the taxpayer comprised of graduates and diploma holders, engaged in mere execution of pre-determined support activities. It was held that with the assembled workforce not venturing into decision making or entrepreneurial activities, the argument of the Revenue that the taxpayer had created valuable human intangibles does not hold good.

Intangibles pertaining to the Supply Chain

According to the taxpayer, it functioned on a fully guided model with GAP USA developing and owning all valuable assets pertaining to business operations such as vendor lists, business information, software, business processes, etc. In support of its argument the taxpayer submitted documents such as vendor handbook, manual etc. The Tribunal noted that the taxpayer’s role, activities and suppliers / vendors were already identified by GAP USA. The taxpayer was merely following instructions from GAP USA, and that can’t lead to creation of intangibles at the taxpayer’s level.

Location Savings

The taxpayer placed detailed submissions before the Tribunal regarding the location savings argument. The taxpayer argued that due to business operations in a highly competitive environment, any such benefit is passed on to the ultimate customers in the form of lower sales price. Thus no location specific advantages exist. Even if any such advantage existed, relying on the economics of location specific benefits, the allocation would be based on the relative bargaining powers of the parties. In the case of low risk service providers like the taxpayer, the bargaining power is insignificant, denying the taxpayer of any share in the location savings pie.

The Tribunal observed that the element of location savings in a developing economy is a characteristic of the entire industry, and not just the taxpayer. Location specific savings, if any, would be captured in the profitability of the comparables used for benchmarking the international transaction. Thus no separate allocation/addition is required to be made on account of location savings.

Profit Level Indicator

While accepting the Profit Level Indicator (“PLI”) of the taxpayer, the Tribunal made an observation that the chosen compensation model should reflect the ground commercial and economic realities of the industry resulting in reasonable profitability, and not absurd profitability as sought by the Revenue in the instant case. Further, the Tribunal concluded that in case of a non-risk bearing entity, a cost plus remuneration with operating profit/operating costs as the PLI is more appropriate and not a commission based model. Further, the Tribunal held that the arm’s length mark-up for the taxpayer should be 32%, looking at the case of Li and Fung India Pvt. Ltd and the analysis put forward by the taxpayer.

SKP’s comments

  • It is extremely critical to determine the FAR profiles of the taxpayer and the AEs. The remuneration model adopted should appropriately reflect the underlying commercial and economic realities. Robust documentation and agreements should be maintained to support the FAR sketched.
  • This case is another strong indicator of the inclination and capability of the Revenue to dig into complex transfer pricing issues such as intangibles. It is imperative for taxpayers to be prepared with upfront robust transfer pricing documentation and contractual agreements.
  • The case also touches upon the pertinent issue of location savings in the Indian context. Even in the global transfer pricing arena, the subject has been garnering significant attention due to the growth of foreign direct investments into emerging economies such as the ‘BRICS’ countries (Brazil, Russia, India, China, and South Africa), with India and China leading the way.
    From an Indian perspective, a robust FAR analysis is critical to counter arguments based on location savings. Within the FAR analysis, emphasis is placed on factors such as ownership and value of intangibles that impact the bargaining power analysis. Further, other economic factors such as the state of competition (and ‘leakages’ in the savings) should be well analyzed and documented.
  • The Tribunal has made welcome observations in adopting a PLI that is fair and in tandem with the economic substance of the transactions.