ITAT Ruling: The Tribunal held that the Transfer Pricing Officer cannot exceed his limitation by following any method to determine the arm’s length price which is not authorised by the Income Tax Act or the Income Tax Rules
CA Computer Associates Pvt. Ltd. (assessee) was incorporated during the year 1998 and was a 100 % subsidiary of Computer Associates International Inc. USA (CA – USA). The assessee was primarily engaged in the business of (i) licensing mainframe mid range and system infrastructure software products of CA Management Inc. USA (CAMI – USA); (ii) software that can be generally deployed “Out of box” or with customer/ industry specified adaptations; and (iii) development software that can allow technologies and programmes to write custom applications and create new categories of packaged applications. The assessee had set-up a Technical Support Centre in Chennai to provide support services to end users of the software products on behalf of the CAMI – USA. As per the agreement with CAMI – USA, the assessee was appointed as the sole distributor of the products of CAMI – USA in India.
The assessee for the assessment year (A.Y.) 2002-03 had declared a loss in its return of income. The case was selected for scrutiny and was referred to the Transfer Pricing Officer (TPO) by the Assessing Officer (AO) for determining the arm’s length price (ALP) of the international transaction entered into by assessee with its associated enterprises (AEs). The assessee had paid royalty amounting to Rs. 7,43,22,376 to CAMI – USA for distribution of the software products in India. The assessee had bench marked this royalty payment using Comparable Uncontrolled Price Method. However, the TPO had determined the ALP at NIL in relation to the royalty to the extent of Rs. 47,09,755 paid to CAMI-USA, which was corresponding to sales of Rs. 13,33,44,452 written off as bad debts in the books of account, on the following grounds:
- The TPO observed that the assessee had written off sales amounting to Rs. 13,33,44,452 as bad debts and the invoices pertaining to these sales were also raised by the assessee during the same financial year relevant to assessment year under consideration. Further, the decision of write off was also taken in all the cases in the meeting of Board of Directors of the company held on 7 March 2002 in the same financial year.
- Once the decision of write off of bad debts for the invoices raised during the previous year was taken on 7 March 2002, this amount would get reflected as amount non-receivable in the monthly reports, which would be available with the licencor. If such reports were available with the licencor for the amount of invoices raised during the year and written off during the year, the licencor should not have claimed royalty on such amounts written off, in the debit note raised on 31 March 2002.
- Any independent entity, acting as a sole distributor of the off- the- shelf product of a licencor, would have sought for a waiver of royalty payable, considering the huge amount of non-receivables which ultimately it is forced to write off as bad debts.
- The assessee should have asked for a waiver of royalty corresponding to such write off, any independent entity, who is just distributor of the products, could have asked for such waiver, irrespective of the agreement provisions. When the assessee could not realise the amounts from the clients, for the products distributed, belonging to CAMI- USA, how could a Royalty can be considered as payable. The independent entities acting independent of each other, would certainly enter into agreement for payment of Royalty, on the basis of actual collections made and not on the basis of just invoicing.
- The contention of the assessee that it paid royalty at a lesser rate than paid in comparable uncontrolled transactions. This contention is not relevant in the present issue, because regarding the rate of royalty, there is no dispute, of being at Arm’s Length but issue at hand deals with the specific issue of royalty on write off of the invoiced amount during the year, itself.
- In view of the fact that the assessee was only acting as Distributor, the products belonged to the licensor, these were the initial years of the business of the assessee, in the country, the bad debts risks were likely to be there, these facts would certainly be considered by the Independent Parties, while entering into distributor agreement and non-payment of royalty, on non realisation of the proceeds would certainly be a condition in agreement entered at arm’s length.
The assessee filed an appeal against the above adjustment made by the TPO, which had however been upheld by the Commissioner of Income Tax (Appeals) [CIT(A)].
The assessee filed an appeal against the CIT(A)’s order before the Income Tax Appellate Tribunal (ITAT). The core issue before the ITAT was not the method, which had been adopted for determining the ALP; but the way it was determined by the TPO.
Contention of the Assessee before the ITAT:
The assessee argued that the jurisdiction of the TPO is restricted to determine the ALP of any international transaction in view of the power vested in him under section 92CA(3) of the Act. The assessee further argued that write off of the bad-debts cannot be the subject matter for determining the ALP so as to power of the TPO is concerned. Merely because royalty payments were relating to the product sold by the assessee to its client and the payment from them could not be recovered, cannot be the consideration before the TPO for deterring ALP of any international transaction. When specific methods have been prescribed in the Income Tax Act, 1961 (Act) and the Income Tax Rules, 1962 (Rules), the TPO is bound to determine ALP of any international transaction within the framework of the method prescribed by the Act.
ITAT Observation and Ruling:
The ITAT has observed that the manner in which the ALP is to be determined by any of the method is prescribed in section 92C of the Act r.w.r 10B of the Rules. After examining the parameters prescribed in Rule 10B, it can be seen that bad debts written off cannot be factor to determine the ALP of any international transaction. The TPO has exceeded his limitation by following the method which is not authorised under the Act or Rules. Therefore the ALP determined by the TPO and adopted by the AO to the extent of royalty payable to the CAMI – USA is not as per the procedure prescribed and same cannot be sustained. The AO has been directed to adopt the ALP of the royalty payable to CAMI-USA as declared by the assessee.
Under the Transfer Pricing Regulations (TPR), any income or allowance for any expenses arising from an international transaction shall be computed having regard to the arm’s length price. The ALP cannot be determined merely on the basis of the methods prescribed under section 92C(1) r.w. Rule 10B. The application of the methods hinges on the functional and economic analyses, which are the cornerstones of transfer pricing. Transfer pricing is not an exact science. Therefore, it may not be necessary that methods prescribed under the TPR are the only means for determining the arm’s length nature of the controlled transaction. The dynamic nature of business may not always allow the application of the specified methods for bench marking unique transactions. We believe that the arm’s length standard, which is the foundation of transfer pricing law in India and throughout the globe, is flexible enough to absorb the vicissitudes of business and is not straight jacketed by only methods specified in law. Thus, this decision should be read with the facts of the case and may not have universal application for all unique transactions.
We believe that the royalty is normally paid to the licencor for the exploitation of intangibles and therefore, the exploitation of intangibles and realisation of sales by the licensee are two independent transactions, although the compensation methodology for royalty is normally based upon the turnover of the licensee. Otherwise, the basic intention of entering into a licensing arrangement would get defeated as the licencor would always share in the profit or loss of the licensee, as per the stand of the Revenue Authorities.