Captive software service providers, clamped with hefty tax demands for violation of transfer pricing norms in transactions with their US parent, could have some respite. According to a recent ruling by the income Tax Appellate Tribunal (ITAT), captive software units that provide risk-free services to their US parent companies make significantly lower profits than their counterparts earning income from "other sources." Lower profits would generally soften the tax burden, if any, for the captive subsidiary.

The ruling was given to E Gain Pvt Ltd, a 100% EOU approved by the Software Technology Park of India (STPI). Transfer pricing norms apply to such companies even if they enjoy a tax holiday on their export profits. Transfer pricing refers to the price charged by one group company to an associated enterprise for an international transaction relating to supply of goods, services and property.

Since transfer prices can be used to shift profits out of the country and hence avoid taxes, India has a regulation in place to check such violations. The law says that income accruing from such a transaction should be at arms length price.

Captive software developers in India often face problems on comparability. This happens when transfer pricing officers (TPO) compare international transactions of the tax payer with independent companies not comparable with captive units to arrive at the arms length price.

The ITAT ruling makes it clear that companies with whom comparisons are being made should be in the same line of business as the tax payer. Else, it would inflate the profit margins of the tax payer. This is exactly what happened in case of E-Gain.

The company had benchmarked the international transaction based on a cost plus mark up of 5% during the tax year of March 31, 2004. But the TPO computed the average net cost plus at 16.12% and made an adjustment. The ITAT held that E Gain was not bearing any transactional risk on its international transaction with the American parent and hence risk adjustments were required to enhance comparability with comparable companies.

"While doing a transfer pricing analysis, one has to look at the abnormalities not only of the tested companies but also that of the comparable companies and eliminate them. Only then it is possible to have a like to like comparison for making adjustments," says TP Ostwal, who argued this appeal for the tax payer in India.

The lessons, parameters such as the line of business, product or services, assets employed, size and scope of operation, the stage of business or product cycle should be considered while making comparisons. In case of comparable companies, operating income attributable to assets other than the ones under consideration needs to be adjusted before working out the net cost plus mark up.

According to Samir Gandhi, tax partner, Deliotte Haskins & Sells, this could be an opportune moment to consider the introduction of the full arms length range concept (instead of 5% at present) for benchmarking analysis in India. India should also consider the introduction of safe harbour or minimum acceptable mark up for the IT and ITes sectors.