Attuning transfer pricing regulations to new complexities
August, 02nd 2007
The recent order of the Income tax Appellate Tribunals (ITAT) special bench, Bangalore, in the case of Aztec Software and Technology Services (Aztec India) has brought to the forefront, once again, certain issues relating to transfer pricing.
This order is the first ITAT decision in India encompassing both legal and economic aspects of transfer pricing. Broadly, it has reaffirmed the validity of the legal and procedural aspects of the Indian transfer pricing legislation. But, perhaps the Indian transfer pricing regulations need to be more attuned to the needs of global market players.
Aztec India, a tax holiday eligible company, remunerated its wholly owned subsidiary in the United States (US) on a cost plus basis. The mark up was agreed at 10 per cent for marketing services and 5 per cent for onsite software services.
As the value of the international transactions, between the Indian parent and its US subsidiary was more than Rs. 5 crore, a reference was made to the Transfer Pricing Officer (TPO) in accordance with the internal circular issued by the Central Board of Direct Taxes (CBDT).
The TPO rejected the transfer pricing analysis undertaken by Aztec India on multiple grounds. Subsequently, on the basis of the TPOs order, the Assessing Officer (AO) made adjustments to the total income of the taxpayer. Aggrieved with the AOs order, Aztec India appealed before the Appellate Commissioner of Income Tax -CIT (A).
The CIT(A)s order was in favour of Aztec both on procedural and legal grounds and the transfer pricing adjustment made by the AO was deleted by the CIT(A) citing technical deficiencies in the TPOs approach while determining arms length price. While this order was binding only on Aztec and the tax department in respect of the year under appeal, viz: FY 2001-02, some of the observations arising from the order were perceived as being of relevance to other companies where matters relating to transfer pricing adjustments were under appeal.
Subsequent to the issue of this order, the tax department filed an appeal and a cross appeal was filed by Aztec with the ITAT.
Analysis of legal grounds
The legal positions arising out of the ITATs order relating to a reference to be made to the TPO include: There is no legal requirement for the AO to demonstrate tax avoidance before invoking transfer pricing provisions;
The AO need not form an opinion on any one or more of the following before making a reference to the TPO correct determination of the arms length price (ALP) by the taxpayer, proper transfer pricing documentation, use of correct data or furnishing of required information.
Discretion is given to the AO to refer the case to a TPO if he thinks it is suitable, appropriate, profitable or convenient to the tax department. There is nothing in the tax provisions to suggest that the AO should hear the taxpayer or record reasons before making a reference to the TPO. However, if any material is used against the taxpayer then it should be brought to the taxpayers notice.
The ITAT also held that circulars of the CBDT are binding on the tax department. Thus, when the tax provisions are read with the CBDTs circular, the AO has no discretion, but has to refer the matter to the TPO where the value of the international transactions exceeds Rs 5 crore in a financial year. Further, it commented that subsequent to the amendment made by the Finance Act, 2007, the TPOs order is binding on the AO.
Safe harbour provisions
No one can deny that India is on the growth path and a force to reckon with in the global market place. The Organisation for Economic Co-operation and Developments (Oecds) transfer pricing guidelines illustrate that safe harbours can have two variants: Certain transactions can be excluded from the scope of application of transfer pricing provisions (in particular by setting thresholds), or the transfer pricing rules applying to these transactions are simplified (for example, by designating ranges within which prices or profits must fall).
Countries such as UK and even Mexico have provided for safe harbours for small and medium enterprises in some manner or the other. In India, while the safe harbours such as alleviation of documentation requirements for small taxpayers exist, there remains some scope for improvement on this aspect. Safe harbour provisions could also be implemented for certain transactions such as software development services, IT enabled services, back office support services etc and if such transactions are conducted on a cost plus a certain specified mark-up the transaction could be deemed to have complied with the arms length principle.
If the range is outside the specified limits, the taxpayer should be given an opportunity to establish the arms length price of the transaction. Global players have also been suggesting introduction of an advance pricing mechanism, which enable determination of the arms length price with the tax department and avoid litigation at a later date.
Analysis of economic
As regards issues relating to the transfer price itself, a few issues were examined, some of which are detailed below.
Relying on the OECDs transfer pricing guidelines and US transfer pricing regulations, the ITAT validly held that the use of unadjusted industry average returns by the TPO, without accounting for transactional level differences taking into consideration the risks and functions of the tested party, was not valid and should be set aside. . The ITAT also held that any changes in the most appropriate transfer pricing method chosen by the tax payer have to be dealt with by a speaking order and the TPO has to reject the method used by the taxpayer based on proper reasoning, which seems reasonable.
Transfer pricing provisions presently permit selection of the most appropriate method out of the prescribed methods. There is perhaps a need to permit taxpayers to choose an unspecified method, which is the most appropriate to that particular transaction.
Choice of tax method
International transactions will continue to grow in complexity covering transfer of intangible property rights, cost contribution arrangements, intricate financial transactions, to name a few. Thus, taxpayers should be allowed to choose a method which is not specified but which is most appropriate to such transactions. After debate with global players impacted by transfer pricing, the transfer pricing procedure and regulations must be suitably amended.
(The author is the national tax director and partner, Ernst & Young, India)