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Keeping transfer pricing at arms length
December, 22nd 2007

While transfer pricing is not an exact science, the analysis must be judicious and consider all the relevant facts of the case.

Mentor Graphics India (Ind Co) is engaged in providing software development services to its parent company in the US. While preparing its transfer pricing documentation under Indian transfer pricing rules for the relevant tax year (2001-02), the taxpayer selected the Transactional Net Margin Method (TNMM) as the most appropriate method for determining the arms length price.

The Transfer Pricing Officer (TPO) rejected the transfer pricing analysis undertaken by Ind Co on several grounds and determined the arms length margin to be 24.53 per cent. On the basis of the TPOs order, the Assessing Officer (AO) made adjustments to the total income of Ind Co. The transfer pricing adjustment was upheld by Appellate Commissioner of Income Tax [CIT(A)], the first-level appellate authority. Aggrieved by the CIT(A) ruling, Ind Co filed an appeal before the ITAT (Income Tax Appellate Tribunal), the second-level appellate authority. In its ruling, the ITAT has laid down the following general principles for selection of comparable data for performing a transfer pricing analysis:

While transfer pricing is not an exact science, it has to be shown that the analysis carried was judicious and was done after taking into account all the relevant facts and circumstances of the case. For determination of arms length price (ALP), the transfer pricing rules require all the characteristics of the controlled transaction that are likely to affect its open market value to be taken into account.

Important considerations

The risks assumed by the respective parties is a very important consideration in a transfer pricing analysis. If there are material and significant differences between the controlled enterprise and the comparable companies, the differences may need to be eliminated by making appropriate adjustments. In light of the above general principles, the ITAT rejected the analysis performed by the TPO for the following reasons: The TPO has not given due consideration to the above-mentioned factors for judging comparability. The TPO had drawn conclusions based on certain presumptions which cannot be accepted.

The ITAT held that the approach adopted by the TPO in selecting comparable data had serious defects which materially affected the determination of arms length price, and cannot be said to be legally correct. The ITAT also observed that the TPOs approach was not consistent with the transfer pricing rules nor were in conformity with the OECD Guidelines and had, therefore, resulted in a faulty comparison. The ITAT also observed that the taxpayer had carried out proper screening for comparable companies, which considered functions, risks and assets. It also acknowledged that though identical transactions could not be located even by the taxpayer, an attempt was made to find comparable transactions as close as possible to the controlled transaction.

Observations and comments

Being one of the first rulings by an ITAT on a substantive transfer pricing issue of determining arms length price, the ruling does provide general guidance on the approach to be adopted in selecting comparable data.

The ruling reinforces the importance of well documented comparability assessment in a transfer pricing analysis. The emphasis placed by the ITAT on the relevance of risk in transfer pricing would be useful for captive service providers who assume very little risk in their international transactions. The reference made by the ITAT to OECD Guidelines and international case laws seems to suggest that in the absence of adequate guidance in India, Courts are inclined to rely on international practices for resolving these issues. The ruling also highlights the importance of proper transfer pricing documentation and the need to ensure objectivity in selecting comparable data for defending a transfer price.

While the ruling does provide some guidance on the contentious issue of selecting comparable data for a transfer pricing analysis, it has not addressed a number of other controversial issues. For instance, while it acknowledges that risk differences could have a significant impact on a transfer price, no guidance has been provided on the approach to be adopted for making such adjustments. Similarly, the ruling has not addressed the impact on transfer pricing, if any, on account of location savings likely to arise from outsourcing services to an Indian affiliate. From the ruling it appears that these issues were not presented by either party before the ITAT.

While the ruling is likely to be welcomed by a number of other taxpayers, it may have limited precedent value in cases where there are even minor variations in facts. Nevertheless, the general principles emerging from it can be expected to have some persuasive value. Further, as matters relating to selection of comparable data are largely factual, it needs to be seen if a High Court accepts an appeal against the ruling (if the Revenue prefers to do so) as only matters involving question of law may be appealed to the High Court and the ITAT is the final fact-finding authority.

Rajendra Nayak
(The author is Partner in the International Tax Services Group of Ernst & Young India)
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