Arithmetic mean is the common average, as you may know. But are you aware that for the information technology (IT) industry arithmetic mean in transfer pricing (TP) regulations is an irritant?

The issue has drawn attention, especially after there have been arbitrary adjustments made by income-tax authorities during the course of TP assessments for captive IT and ITeS (IT-enabled services) enterprises.

For starters, `transfer pricing' refers to `the pricing of goods and services within a multi-divisional organisation, particularly in regard to cross-border transactions,' as Wikipedia defines. And `captive units' are dedicated in-house units, as distinguished from third-party service providers.

IT services encompass software development, software maintenance and so on; and ITeS includes a large number of services entailing outsourcing of a business process such as voice-based call centres, medical transcription, payroll processing, and accounting work.

The fundamental basis of any TP assessment, for tax purposes, is the benchmarking exercise vis--vis comparable companies, so questions arise when the margins arrived at by the taxman are too different from normal profits in the industry.

There is an immediate need to ensure that the tax authorities are not purely driven by revenue considerations but adopt a more equitable and fair approach in arriving at arm's length results of units in the IT/ITeS industry, argues a recent `technical memorandum' submitted to the Finance Minister by BSR & Co, a firm of chartered accountants (CAs).

Operating margins

It seems the expectation of the revenue authorities from captive IT/ITeS units is to earn about 25-40 per cent operating margins on costs. Is that reasonable? No, says the CA firm, because the rationale behind off-shoring of ITeS to India has been to leverage on cost advantage in a free global market.

"Economic analyses connected with the off-shoring of business processes have pointed to a total cost saving of about 10-20 per cent after assuming a compensation of around cost plus 10-12 per cent for the captive units," explains the paper.

"If TP assessments confront the captive units with margins as high as cost plus 25 per cent for software service companies and cost plus 37 per cent for ITeS companies, the result would be to defeat the very purpose of off-shoring, and multinational enterprises may find it more economical to leave the shores of India to more competitive destinations such as Romania, the Philippines and Hungary."

The prospect sounds scary, and the thorn in Indian TP regulations may well be the concept of arithmetical mean. How so? "The arithmetical mean represents an average of the given set, which represents the industry. However, considering the fact that the TP authorities are rejecting all loss making comparables, the industry results would be only represented by profit-making companies, which does not represent the factual reality."

A case of selective average, perhaps, leading to skewed results and `unfortunate miscarriage of TP principles'.

The way out

So, what is the way out? We need to move from the arithmetical mean standard to the inter-quartile range, says the memorandum, because the arithmetical mean is affected by the absolute values of various constituents of the given set. Inter-quartile range is a statistical measure that eliminates companies that are `outliers' i.e., companies earning higher than normal profits as well as those earning lower than normal profits, states the memorandum.

"This is based on sound economic logic considering that captive units earn a stable, virtually guaranteed return as opposed to fluctuating returns earned by entrepreneurial enterprises."

Such an approach would be in tune with international legislation and practice, points out the firm. "The US transfer pricing regulations (`US 482 Regs') (Section 1.482-1(e)(2) - Determining of Arm's Length Range), inter alia, prescribe that if material differences exist between the controlled and uncontrolled transactions, adjustments must be made to the results of the uncontrolled transaction so that the arm's length range will be derived only from those uncontrolled comparables that have, or through adjustments can be brought to, a similar level of comparability and reliability."

For the avid, Section 1.482-1(e)(2)(iii)(B) has more: "The reliability of the analysis is increased when statistical methods are used to establish a range of results in which the limits of the range will be determined such that there is a 75 per cent probability of a result falling above the lower end of the range and a 75 per cent probability of a result falling below the upper end of the range. The inter-quartile range ordinarily provides an acceptable measure of this range."

At the very least, `adjustment' should be permitted to eliminate `outliers' and compute arithmetical mean of the comparable companies remaining in the inter-quartile range, pleads the document.

D. Murali