Volume 6, Issue 6

13th May, 2013

Tax Alert

Foreign associated enterprises can never be taken as tested parties in Transfer Pricing


In performing any transfer pricing analysis, it is critical to determine which company’s profitability is to be tested / benchmarked (regarded as tested party in transfer pricing terminology) against the comparable companies. Generally, the "tested party" would be the least complex of the transacting entities, i.e., the simpler entity in terms of intensity of functions performed and risks assumed; and would also not own valuable or non-routine intangibles.

However, recently, the Mumbai Bench of the Income Tax Appellate Tribunal (ITAT), in the case of Onward Technologies Ltd. (the taxpayer), upheld that the foreign associated enterprises (AEs) cannot be selected as a tested parties. Moreover, the ITAT has also held that the overall profits of the group / AEs has no relevance in determining the ALP of an international transaction.

Facts of the case and taxpayer’s approach:

  • The taxpayer, an Indian company is engaged in the business of providing Engineering Design Services and IT consultancy services and has its marketing subsidiaries in USA and Germany (AEs). The AEs also carry out onsite support services along with the marketing. The AEs are remunerated on a cost plus 5% mark-up.
  • The sale price charged by AEs to ultimate customers in overseas regions was equal to the price charged by the taxpayer from its AEs, and hence, the taxpayer contended that transactions between itself and AEs were at arm’s length price (ALP).
  • The taxpayer had adopted the Transactional Net Margin Method (TNMM) using foreign AE as tested party. It arrived at a set of six foreign comparables which are also engaged in providing marketing services as that of AEs.
  • The average margins of these comparables were 4.07% on the costs as against 5% in case of the AEs of the taxpayer. The taxpayer thus concluded that its international transactions were at ALP.

Tax Authorities approach:

  • The Transfer Pricing Officer (TPO) rejected the taxpayer's transfer pricing analysis. The TPO rejected foreign AEs as tested parties and considered the taxpayer as the tested party.
  • The TPO then selected a fresh set of 20 Indian comparable companies and benchmarked the international transaction by considering the margins of these 20 comparables at 20.68% on costs as compared to taxpayer’s operating margins of 14.05% on costs. Thus, the TPO proposed an adjustment of Rs.14.6 Million.
  • The Dispute Resolution Panel (DRP) affirmed the adjustment proposed by the TPO and aggrieved by the DRP’s directions, the taxpayer filed an appeal before the Tribunal.

Taxpayer’s arguments before ITAT:

The taxpayer made the following arguments before the ITAT in support of its transfer pricing analysis:

  • The taxpayer firstly argued that since the sale price received by the foreign AEs from the services ultimately sold to customers is equal to that charged by the taxpayer to its AEs, the international transaction between the taxpayer and the AEs should be considered to be at ALP.
  • The second contention of the tax payer was that the tax authorities cannot go beyond the overall profit of the group in determining the ALP of the international transactions because there is no shifting of profits outside India.

ITAT’s Ruling:

  • The ITAT has focussed on the TNMM adopted by the taxpayer and explained the modus operandi of determining ALP under TNMM. While interpreting the application of TNMM, the ITAT observed that the profit rate earned by the ‘taxpayer’ from a transaction with AE is to be compared with the profit rate of either internal or external comparables for ascertaining as to whether it is at ALP.
  • The ITAT categorically held that there can be no question of substituting the profit realized by the Indian taxpayer from its foreign AEs with the profit realized by the foreign AEs from the ultimate customers, for the purpose of determining the ALP.
  • In fact, the ITAT observed that contention of the taxpayer in considering the profit of the foreign AE for the purposes of comparison with profit of comparables (foreign), to determine the ALP of transaction between the assessee and its foreign AE is patently an unacceptable position having no sanction of the Indian transfer pricing law. Thus, the ITAT held that foreign AEs can never be selected as the tested party for the purpose of determination of ALP.
  • Further, the ITAT also rejected the contention of the taxpayer that the authorities cannot go beyond the overall profit of the group of AEs in determining the ALP, since such a contention is neither backed by the statutory mandate nor stipulated under any of the prescribed methods.
  • The ITAT further held that taxpayer has altogether changed the characterisation of international transaction by substituting the transaction of providing software and technical support services to AEs with that of remunerating the AEs for marketing and sales support services.
  • The ITAT further observed that the Revenue authorities are not bound to follow a method accepted in an earlier year, if it is not in line with the statutory provisions and can adopt a correct method in a subsequent year.
  • On the approach of the TPO, the ITAT found some infirmities with respect to calculation of operating margin and selection of comparable companies and remanded the matter back to the file of AO / TPO for rectifying these infirmities.

SKP’s Comments:

  • There has been a spate of recent rulings on the above principles in the cases of Cybertech Systems & Software Limited and Aurionpro Solutions Limited, where the Tribunal has held, as a general proposition, that the Indian taxpayer would always need to be taken as the "tested party" for the purposes of transfer pricing analysis; and the foreign associated enterprise (AE) cannot be selected as the "tested party".
  • The aforesaid dictum significantly deviates & runs contrary to the fundamentals & canons of TP. With due respect to the ITAT, its observations that under the Indian TP regulations, the foreign AE can never be taken as the "tested party" are not correct & are against the principles of TP. In fact, the basic principles of selection of tested party, guidance provided by OECD and UN TP guidelines, and some rulings of other coordinate benches of ITAT were not at all argued / brought to the notice to this bench of ITAT.
  • The term "enterprise", used while defining the various TP methods (including TNMM) in Rule 10B of the Income Tax Rules, does not refer to only the Indian taxpayer for being subject to benchmarking analysis by always selecting the same as the "tested party". The term "enterprise" in Rule 10B refers to either of the two AEs involved in the "international transaction". Now, which of the two AEs should be selected as the "tested party", for the purposes of economic or benchmarking analysis, would be decided based on which is the least complex of the two transacting entities. This approach is clearly provided in the OECD & draft UN TP guidelines; and also accepted by the ITAT in the cases of Development Consultant & Mastek. 
  • Further, the ITAT has also deviated from the economic principles underlying the TP theory which advocates that the overall profitability of the group also needs to be considered while determining the ALP for the international transactions.
  • The ruling has again added fuel to the ever evolving debate of tested party and these issues are far from getting settled in the Indian context. The key in such a case would be to present the factual matrix before the tax authorities and to support the actual dealing, by way of documentation and other corresponding evidences.