Case Law Details
z ITAT Delhi has recently pronounced its ruling in the case of ST Microelectronics Private Limited Vs. CIT(A), wherein it upheld the revenue’s rejection of transfer pricing analysis undertaken by the taxpayer since the taxpayer had improperly characterized itself as a low-risk software service provider and accordingly, selected wrong com parables for the transfer pricing analysis. Besides, the decision also reiterates that it is a mandatory requirement of Rule 10B(4) of the Income-tax Rules 1962 [“the Rules”] to use current year data for comparability analysis.
Facts
The taxpayer is a subsidiary of ST Microelectronics Pte Ltd., which in turn is a wholly-owned subsidiary of ST Microelectronics Neitherland. It is a 100% EOU set up for rendering integrated circuit design, CAD tools and software development services to its group entities [“AEs”].
During the assessment years [“AY”] 2003-04, 2004-05 and 2006-07, the taxpayer rendered the aforesaid software development services, along with provision of certain marketing support services, to its AEs. For the purpose of bench marking, the taxpayer aggregated these two types of services since the latter formed a very insignificant part of the entire revenue. Further, transactional net margin method [“TNMM”] was selected as the most appropriate method with OP!OC as the profit level indicator [“PLI”]. The taxpayer characterized itself as a low-risk captive software service provider and accordingly identified comparable companies engaged in software development. It computed com parables’ margins using multiple-year data and claimed its transactions to meet the arm’s length principle by the application of +!- 5% benefit as provided in the regulations.
During the course of assessment proceedings, the transfer pricing officer [“TPO”] analysed the functional profile of the taxpayer and observed that the taxpayer had improperly characterized itself as a low-end captive software service provider, whereas it was actually a high-end service provider, performing the most critical part of the value chain and deploying highly qualified technical personnel.
Accordingly, the TPO rejected the transfer pricing analysis of the taxpayer and identified a new set of comparable companies using various filters i.e. rejecting companies with total sales below INR 10 crore and above INR 1000 crore, employee cost! total cost below 10%, OP!TC more than -20% or more than 80%, related party transactions [“RPT”] more than 30% and dissimilar functional profile. Since the current-year data of these comparable companies exceeded taxpayer’s PLI by more than 5%, therefore the TPO made an upward adjustment to the total income of the taxpayer.
Against the order of the TPO, the taxpayer approached the Commissioner of Income-tax (Appeals) [“CIT(A)”] for AY 2003-04 and 2004-05 and Dispute Resolution Panel [“DRP”] for AY 2006-07, where it contested its re-characterization as a high-end service provider by the TPO, mechanical reference of the case to the TPO, rejection of its transfer pricing analysis without pointing out any specific defects, use of only current-year data and denial of benefit of +!- 5% by the TPO.
The CIT(A) concurred with the TPO’s reasoning except that it altered the limits of RPT filter to 0% and employee cost!total cost filter to 25%. Thereafter, he computed the margins of the final comparable companies and consequently, adjustment made by the TPO was marginally reduced. The DRP, however, upheld the transfer pricing order for AY 2006-07 in totality.
Aggrieved by the order of CIT(A), the taxpayer filed an appeal before the Tribunal for all the three years. It presented a diagram depicting the entire value chain analysis of semi-conductor chip and demonstrated that its involvement was restricted to only one stage with a limited scope of work. Thus, it was claimed that its re-characterization as a high-end service provider was incorrect. The taxpayer also claimed risk adjustment since the TPO had compared it to full-fledged entrepreneur companies for comparability analysis. It also pleaded that the use of multiple year data since use of current year data (which was not available at the time of conducting TP analysis) would cause undue hardship to the taxpayer and benefit of +!- 5% should be granted. Finally, the taxpayer claimed that margins of some com parables were wrongly computed by the TPO in the AY 2006-07.
The revenue also filed an appeal against the order of CIT(A) for AY 2003-04 and 2004-05.
Ruling of the Tribunal
The Tribunal, while upholding the order of TPO for all the three years, observed and remarked as under:
- The Tribunal observed that the taxpayer’s role in the value-chain analysis was limited, but highly important since its operations required highly skilled manpower and the final product was very complex in nature. Accordingly, the taxpayer’s re-characterization as a high-end service provider by the TPO was correct. While arriving at this decision, the Tribunal also paid regard to the taxpayer’s vast employee base of more than 1600 persons and it being one of the largest design centers out of Europe
- By making a reference to Rule 10B(2) and 10B(3), the Tribunal remarked that determination of arm’s length price is a fact intensive exercise and there is no scientific formula to compute the same with mathematical precision. It approved of the search methodology adopted by the TPO and remarked that the taxpayer had failed to consider two key drivers of IT industry, viz. highly-skilled manpower and turnover in its search process. The Tribunal also ruled that the TPO is not required to record specific findings before proceeding to select fresh com parables – the only requirement is that the approach of the TPO ought to be judicious
- The Tribunal observed that use of the expression “shall” in Rule 10B(4) makes it amply clear that it is mandatory to use the current year data except in circumstances where it can be brought on record that prior two years’ data had a bearing on the current year’s transfer prices
- In respect of the benefit of +/- 5% range, the Tribunal held that tolerance band is not available as a standard deduction
Conclusion –This decision signals the Tribunal’s approval of the Revenue’s approach to place a captive service provider in the value-chain and the validity of an economic analysis based on such characterization.
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