Recent Tribunal rulings on transfer pricing issues in the case of Global Vantedge Pvt. Ltd and Quark Systems Pvt. Ltd.

The Delhi Tribunal, in the case of Global Vantedge Pvt. Ltd. (Taxpayer) [2010-TIOL¬24-ITAT-DEL], has held that the total amount of adjustment made, along with the arms length price (ALP) already reported by the Taxpayer, cannot exceed the total amount of revenues earned by the Taxpayer and its associated enterprise (AE) from dealing with third party clients. Further, the Tribunal observed that in undertaking a TP analysis the least complex entity should be selected as the tested party. However, selecting an overseas entity as the tested party may not be appropriate because it is difficult to obtain all relevant facts and data required for undertaking a proper analysis of functions, assets and risks (FAR) and making the requisite adjustments.

In the other case of Quark Systems Pvt. Ltd. (Taxpayer) [2010-TIOL-31-ITAT-CHD¬SB], the SB of the Tribunal has adjudicated on issues regarding the selection of comparable companies. The SB held that if comparable companies did not satisfy the very basic requirements of the FAR analysis then they need to be rejected. The SB observed that if on an analysis of a plain function of services rendered by the comparable party shows that these functions are neither compatible with those of the Taxpayer nor do they belong to the genus to which functions performed by the Taxpayer belong, it would be futile to suggest that merely because the Taxpayer and the comparable company are grouped under the same head in a database, comparability is established.

Decision in the case of Global Vantedge Pvt. Ltd.

Facts of the case

• The Taxpayer is an Indian company and is engaged in providing services to RCS Centre Corp, USA (RCS). RCS is engaged in the business of providing debt collection and telemarketing services to clients in USA. Since RCS does not own the requisite infrastructure or capacity for execution of the work, the same is actually performed by the Taxpayer in India, under an arrangement with RCS. Since the Taxpayer and RCS are AEs, the transactions between them are subject to Indian TP regulations.

• During the tax year 2002-03, the Taxpayer received a remuneration of INR 8.32 crores from RCS for performing services (which was 90.6% of the revenue earned by RCS from third party clients). The Taxpayer is also engaged in rendering services to other independent clients which constituted approximately 18% of its total revenue. In determining the arm’s length nature of its international transaction with RCS, the Taxpayer selected RCS as the ‘tested party’ and performed a comparability analysis. However, during the course of assessments, the Transfer Pricing Officer (TPO) held that in the given circumstances, the Taxpayer, and not RCS, should be treated as a ‘tested party’. Based on the margins earned by the comparables identified, the TPO made an adjustment to the international transaction entered into by the Taxpayer. The average operating margin of the comparables was 11.88%as against the loss of 53.5% incurred by the Taxpayer. Applying the margin of 11.88% on the total operating cost of INR 22.46 crores incurred by the Taxpayer, the TPO made an adjustment of INR 14.7 crores. Being aggrieved by the TPO’s order, the Taxpayer preferred an appeal with the first level appellate authority.

Decision of the first level appellate authority Selection of RCS as the ‘tested party’

• The least complex entity needs to be selected as the ‘tested party’ for the purposes of carrying out an arm’s length analysis because a simpler party requires fewer and more reliable adjustments to be made to its operating profit margins.

• Accordingly, selecting a foreign entity such as RCS as a ‘tested party’ and the consequent use of international comparables would be inappropriate, as it is difficult to compare entitlements in different jurisdictions since the facts and circumstances differ in each geographical location.

• Further, since it is difficult to obtain all relevant facts that could lead to a proper FAR analysis, the use of RCS as a ‘tested party’ was rejected and it was held that the Taxpayer should be regarded as the ‘tested party’.

Revenue sharing between entities

• The Indian TP regulations require only an analysis of the transactions between AEs and not the transactions with third parties, since extraneous factors cannot be controlled.

• Moreover, if an entity is unable to earn adequate profits on account of legitimate business exigencies and not due to manipulation of transactions undertaken by the AEs, such an entity cannot be penalized. Having regard to this, it was held that the total adjustment made in the hands of the Taxpayer, together with the ALP already reported by it, cannot exceed the total revenues earned by the Taxpayer and its AE from the third party independent clients.

• The ALP cannot be equivalent to 100% of the revenues earned by RCS from third party independent clients, as this would imply that RCS performs the marketing activities without any consideration, which is an absurd and an improbable business proposition.

• Placing reliance on a report of the Indian Business Process Outsourcing (BPO) industry prepared by a division of ICRA Ltd. which suggested that, on an average, BPO companies have selling expenses of 1.4-4%, it was held that a share of 1.4% of the revenues is adequate to compensate RCS for its activities and the ALP was fixed at 98.6% of the revenues earned by RCS from its clients. Accordingly, the amount of adjustment was restricted to the difference between the ALP determined above and the actual value of the international transaction.

Ruling of the Tribunal

The Tribunal ruled that since neither the Taxpayer nor the Tax Authority was able to controvert the findings of the first level appellate authority or adduce any material to enable the Tribunal to take a different view, it upheld the order of the first level appellate authority.

Decision in the case of Quark Systems Pvt. Ltd.

Facts of the case

• The Taxpayer is an Indian company and is a fully-owned subsidiary of Quark Systems SARL, Switzerland (QSSS). QSSS is in the business of making specialized software for its clients who are media companies, which is generally used for lay-out of newspapers and periodicals. The Taxpayer is a captive unit working exclusively for QSSS by providing assistance to its Indian clients facing technical problems. It is a dedicated service provider for the said purpose. In consideration of the services rendered, the Taxpayer received a fee computed with reference to associated costs plus a mark-up of 13.5%.

• In the assessment proceedings, the TPO rejected one of the comparable companies, M/s Imercius Technologies India Pvt. Ltd. (Imercius), as it was a start-up company having negative net worth and did not match up to the turnover of the Taxpayer. On appeal, the first level appellate authority upheld the order of the TPO and observed as follows: (a) The turnover of Imercius was just INR 1.45 crores whereas the turnover of the Taxpayer was INR 13.6 crores. (b) Imercius was in the first year of its operation which essentially meant that the expenditure for setting up the business would have been much larger and the turnover would be lower. (c) The personnel expenses of Imercius was unusually high at INR 2.17 crores as compared to its turnover of INR 1.45 crores. (d) Imercius was engaged in transition services and customer contact services which were different from the activities undertaken by the Taxpayer. Being aggrieved by the decision of the first level appellate authority, the Taxpayer appealed before the SB of the Tribunal. Before the Tribunal, it also pleaded on an additional ground for the exclusion of a comparable company, M/s Datamatics Technologies Ltd.(Datamatics), originally selected by it as a comparable company.

Ruling of the SB of the Tribunal

The decision of the Tribunal is summarized below:

Reiection of Imercius

The SB of the Tribunal upheld the order of the subordinate authorities and rejected Imercius as the comparable company for the following reasons:

• The sales and technical support services functions performed by the Taxpayer are inherently of different character and scope than the telemarketing services function performed by Imercius. In telemarketing, fluctuation of profits is very high as the gains are contingent upon the results obtained. The earnings of a telemarketing company are usually a percentage of the sales generated. As against this, in sales and technical support services, the gains are dependent on the services actually rendered by the Taxpayer and are not contingent upon the business results generated by such services.

• If an analysis of a plain function of services rendered by Imercius shows that these functions are not compatible with those of the Taxpayer nor do they belong to the genus to which functions performed by the Taxpayer belong, it would be futile to suggest that merely because the Taxpayer, as also Imercius, are grouped under the same head in Prowess database (a database which contains financial information about companies), comparability is established.

• The risk analysis of the 2 organizations i.e. the Taxpayer and Imercius clearly shows that the 2 entities are not on an even ground. The business risk in the telemarketing activity is much higher than the risk in the Taxpayer’s business.

• A business organization with negative net worth cannot be treated at par with a normal business organization. The turnover of Imercius was only INR 1.47 crores whereas other comparables had a turnover in excess of INR 5 crores and the Taxpayer had a turnover of INR 13.06 crores.

• In relation to the use of a turnover filter for rejecting companies having a turnover of less than INR 1 crore, the Tribunal held that the same is without any reasonable basis and there is no filter for higher turnover at all. It is improper to proceed on the basis that the turnover of INR 1 crore to infinite is a reasonable classification as turnover base.

• Since the very basic requirements of the FAR analysis were not satisfied by the Taxpayer so as to justify its inclusion in the list of comparables, Imercius cannot be accepted as a comparable company.

Exclusion of comparable party originally included by the Taxpayer

• On a prima facie basis, Datamatics is not a comparable entity as it has earned extraordinary profit and has a huge turnover, besides differences in assets and other characteristics. The Tribunal is a fact-finding body and, therefore, has to take into account all the relevant material and determine the question as per the statutory regulations.

• Support was drawn from OECD Transfer Pricing Guidelines 2009 to hold that merely because the Taxpayer itself has selected Datamatics as a comparable company, it is not estopped from pointing out a mistake in the assessment, though such a mistake is the result of evidence adduced by the Taxpayer.

• When substantial justice and technical considerations are pitted against each other, the cause of substantial justice deserves to be preferred. Thus, the Tribunal concluded that since this ground was first admitted only before the Tribunal and not before the Tax Authority, the matter was remitted to the latter for consideration of the claim of the Taxpayer.

Comments

The Tribunal rulings address a couple of significant issues relating to choice of ‘tested party’ and selection of comparable data while undertaking a TP analysis. While the Delhi Tribunal decision reinforces the general rule that the least complex of the entities should be the ‘tested party’, it further identifies the limitations that need to be considered in case a taxpayer wishes to choose a foreign entity as the ‘tested party’. The SB decision provides some useful guidance on the factors that need to be considered while accepting/rejecting comparable data.

By referring to OECD Transfer Pricing Guidelines 2009, the SB ruling has continued the approach adopted by Indian Tribunals in their earlier decisions that such material can be relied upon as an aid in interpreting Indian TP rules, wherever appropriate. The approach adopted by the Tribunals in allowing the taxpayer to relook its comparable data during the proceedings is likely to be welcomed by taxpayers. Further, the Tribunals have made an observation that they have taken a liberal approach on this matter as TP was in the initial stages in the relevant tax year.