Total amount of transfer pricing adjustment cannot exceed the absolute amount of revenue realized by the associated enterprise from third parties

This judgement emphasizes the fact that total amount of transfer pricing adjustment cannot exceed the absolute amount of revenue realized by the associated enterprise from third parties and idle capacity adjustment should be allowed to the taxpayer to improve the comparability analysis.

Facts

Global Vantedge Private Limited (“assessee”) is a subsidiary of Global Vantedge, Mauritius which, in turn, is a wholly owned subsidiary of Global Vantedge, Bermuda. The assessee is engaged in rendering IT enabled services in the field of credit collection and telemarketing services and is eligible for deduction u/s 10A of the Act as a STPI unit. The RCS Center Corporation, USA, (RCS) is wholly owned subsidiary of Global Vantedge, Bermuda. RCS is engaged in the business of contracting with clients located in USA to provide them debt collection and telemarketing services. RCS outsources the work to the assessee. During the financial year 2002- 03 the assessee received Rs. 8,32,66,596/- from RCS for clients services (which is 90.6% of the revenue earned by RCS from third party clients). The assessee is also engaged in rendering services to other independent clients and which consist of approximately 18% of the total revenue.

The assessee selected its AE as the “tested party” as it performed simpler functions of marketing support services. The TPO concluded that in given circumstances associated enterprises should not be treated as a tested party. The TPO chose the assessee itself as the tested party and identified nine Indian companies as com parables. The average operating margin of the com parables was 11.88% as against the loss of 53.5% incurred by the assessee. Applying the Arm’s Length Margin of 11.88% on the total operating cost of Rs. 22,46,97,971/-, the TPO/AO made an adjustment of Rs. 14,70,10,071/-.

Contentions and issues raised by assessee before CIT (A): Being aggrieved by the order of the TPO/AO, the assessee preferred an appeal on many grounds against the additions made by the AO. The crux of issues raised by the assessee may be summarized as under:

1. Assessee being the complex entity, should not be chosen as the tested party.

2. Arm’s length price (ALP) of the international transaction between the assessee and its associated enterprise cannot exceed the total amount of revenue earned from third party clients. The assessee contended that in a revenue sharing arrangement between the entities, what may be questioned is the proportion of sharing between the entities and not the absolute amount of revenue itself which is subject of sharing because that is beyond the control of either the assessee or its AE.

3. In case, the ALP determined by the assessee and the TPO/AO is found to be improper, then what should be the appropriate ALP?

Proceedings before CIT (A):

The decision of CIT(A) on the above said issues are summarized here under:

1. In relation to “tested party” The CIT(A) agreed with the contentions of the assessee that the least complex party needs to be selected as the tested party . However, it was concluded that, based on the facts available, RCS cannot be selected as the tested party for following reasons:

• In absence of adequate information regarding the foreign com parables, a proper FAR cannot be performed.
• The relevant data which may be required to make the requisite adjustments is also very difficult to obtain in relation to the foreign com parables.
• It is difficult to compare the remuneration in different jurisdictions as the facts and circumstances are different in each geographical location.
• Based on above reasoning, CIT (A) ruled in favor of the revenue and concluded that the assessee should be selected as the tested party.

2. In regard to the second issue, of sharing of revenue between Aes, the CIT(A) accepted the contention of the  assessee and ruled in assessee’s favor stating following reasons:

• The Indian Transfer Pricing Regulations only require us to analyze the transactions between associated enterprise and not the transactions with third parties since extraneous factors cannot be controlled.
• 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 associated enterprises, such entity cannot be penalized.

In an extreme case, an entity participating in an international transaction with AE may be required to give up its entire share of revenue which would result in another entity receiving 100% of the total revenue earned. However, it is not logical to say that the fair amount of revenue to be received by the other entity is more than 100% of the total revenue earned by both the entities. Under such circumstances, other entity will have to pay the additional amount from its internal sources which in addition to being a highly absurd proposition, may also lead to the bankruptcy of the other entity. The CIT(A) also mentioned that before proceeding to determine the revenue to be allocated to the assessee, it is pertinent to determine the fair amount of revenue to be received by RCS for its marketing support services.

3. With regard to the question as what would be the appropriate ALP in case the Arms Length Price determined by both the assessee and by the TPO found to be improper, the ld. CIT(A) selected assessee as tested party and applied TNMM method to determine the ALP of international transactions. While determining the ALP, the CIT(A) followed approach as under:

• Determined the percentage of revenue to be received by RCS for its functions. Such percentage was determined on the basis of industry report prepared by ICRA wherein marketing expenses were shown in the range of 1.4% to 4.4% of the turnover. This mean was further substantiated by mean percentage of marketing expense/ turnover incurred by BPO comparable companies which was computed at 1.64%. The CIT(A) finally concluded that the ICRA report is in line with the result of comparable companies and, therefore, RCS is  entitled to 1.4% of the revenue as against 9.6% retained by it. Therefore, maximum revenue that may be allocated to the assessee cannot exceed 98.6% of the revenue earned by the Global Vantage group.
• While applying the TNMN to determine ALP, the CIT(A) reduced the cost base of the assessee for international transaction by 18.14% of the operating cost base on the premise that the assessee earns revenue from third parties to the extent of 18.14%.
• Idle capacity adjustment to the extent of 33.33% was allowed as the assessee was in start up phase.

Based on the above, the CIT(A) re-computed the additions on account of transfer pricing adjustments amounting to Rs. 83,88,625 as against Rs. 14,70,10,071 proposed by the TPO.

Ruling of the ITAT:- Aggrieved by the order of the CIT(A), both the assessee and the department preferred cross appeals before the Honorable Delhi ITAT. The ITAT ruled that since both the parties have not been able to controvert the findings recorded by the CIT(A) or point out any material to enable the Tribunal to take a view other than view taken by the CIT(A), ITAT is inclined to uphold the order of CIT(A) on the point of determination of Arms Length Price in respect of the transactions entered into by the assessee with its associate enterprises, namely, RCS Center Corp.

Conclusion:- The judgement upholds the basic principle that FAR be given due importance for comparability analysis and selection of tested party which normally be least complex entity provided sufficient reliable data is available. The Ruling also establishes the premise that the adjustment made along with the transfer prices of a taxpayer, cannot be more than total revenue realized from third parties. In appropriate cases, adjustment on account of unutilized capacity (e.g. start-up phase) is permissible.

Source: 2010-TIOL-24-ITAT-DEL

NF