Transfer Pricing – ACIT vs. M/s. NGC Network (India) Pvt. Ltd.

It is most appropriate to compare the intra- group transactions for a particular year against independent com parables having data for the same year, if available, where such com parables have already been accepted by the Department for a subsequent year

The Mumbai Bench ‘L’ of the Income Tax Appellate Tribunal (the “Tribunal”), on 23 February 2011, pronounced its ruling in the case ACIT Vs. M/s. NGC Network (India) Pvt. Ltd., Mumbai, ITA No. 5307/M/2008. The Taxpayer’s position under appeal filed by the Department with the Tribunal related to the use of independent comparables under TNMM for justifying the arm’s length nature since the same was accepted by the AO for a subsequent year. The AO argued that the comparables were not acceptable since they were different from functional and operational point of view. The Tribunal, ruled that the most appropriate comparison, under the facts and circumstances of the case, would be between the results achieved by the Taxpayer for the relevant assessment year and those earned by comparable uncontrolled entities during the corresponding period (provided such data is available for comparables), particularly where the set of comparable companies as well as the methodology have already been agreed to by the Department in the subsequent years.

The AO’s had rejected the comparables selected by the taxpayer and instead made transfer pricing adjustment using the license fee paid by the Taxpayer to its AE in the previous year as the basis for determining the arm’s length price. The CIT (A) had negated the adjustment made by the AO on the grounds that arm’s length price cannot be determined by relying on a controlled transaction. The Tribunal however held that merely because a transaction is with an associated enterprise cannot be the ground for rejection of such transaction as an internal comparable, especially where the said transaction closely resembles the one being reviewed, and has already been accepted to be at arm’s length. The Tribunal further held that where the working can rely on previous year’s figures then the controlled transaction undertaken by the Taxpayer in the previous year which has been found to be at arm’s length will give better results since the business is the same.

In light of its observations, the Tribunal set aside the order of the CIT (A) in this case, and restored the matter to the file of the Assessing Officer (“AO”) for reworking the transfer pricing adjustments based on the facts and figures available for the relevant assessment year with respect to the set of comparables selected by the Taxpayer and already agreed to by the Department for a subsequent assessment year.

Facts of the case

The Taxpayer is primarily engaged in the distribution and marketing of National Geographic Channel and the Adventure One Channel, and renders post production services to media companies. During the assessment year 2003-04, the Taxpayer had international transactions totalling INR 137,527,281 with its associated enterprise M/s. NGC Asia LLC (“NGC-Asia”).

The AO, with the approval of the concerned CIT, had referred the matter to the Transfer Pricing Officer (“TPO”) for determination of arm’s length price, but the reference was not accepted by the TPO due to paucity of time. Therefore, the AO asked the Taxpayer to furnish details relating to the computation of arm’s length price with regard to its international transactions with NGC-Asia.

The Taxpayer had performed a transactional net margin method (“TNMM”) analysis to demonstrate the arm’s length nature of its international transactions with NGC-Asia. Specifically, the Taxpayer had identified eight comparable companies (primarily software distributors) and compared their net margins from software segments for the assessment year 2002-03, against the net margin achieved by the Taxpayer for the assessment year 2003-04.

Upon examination, the AO rejected the comparables selected by the Taxpayer and used a set of eleven comparables collected by himself, for the purpose of transfer pricing adjustment for the assessment year 2003-04. The Taxpayer argued that it had carried out due diligence in selection of comparables and the latest data available on the date of due diligence had been applied to demonstrate the arm’s length nature of its international transactions with NGC-Asia. The Taxpayer also argued that the comparables selected by the AO were engaged in broadcasting in television channels which was different from the business of distribution of channels in which the Taxpayer was engaged. The Taxpayer explained that, given the facts and circumstances, companies trading in software were the only companies which could be considered as engaging in activities comparable to the business of distribution of channels, since both involved distribution of an intangible product.

After considering the Taxpayer’s argument, the AO concluded that the comparables selected by neither the Taxpayer nor the AO were suitable for comparison due to differences in the nature of business. Therefore, the AO considered the payments made by the Taxpayer to NGC-Asia during the immediately preceding assessment year 2002-03, for the purpose of comparison based on the premise that such payment had already been found to be at arm’s length. The Taxpayer had paid license fees to NGC-Asia to the tune USD 100,000 per month for the assessment year 2002-03. Thereafter, vide an agreement dated 27 January 2003, the license fees were revised to USD 183,333 per month with retrospective effect from 1 April 2002. When asked by the AO to explain the reason for hike in license fees, the Taxpayer responded that the enhanced license fees were the result of increase in the subscriber base between 2001 and 2003. According to the Taxpayer, the license fee of USD 100,000 per month was decided in cognisance of the fact that National Geographic Channel was a new and novel channel and would take time to establish subscriber base. According to the taxpayer, the subscriber base during this period had doubled and the negotiation regarding increase in license fees was in progress for quite some time before the agreement was reached in January, 2003. Therefore, the Taxpayer contended that the increase in the license fees as well as the retrospective effect of such increase is justified under the facts and circumstances of the case. The AO held that such steep increase in license fees by 84.66 percent was not justified, since the increase in the revenue over the corresponding period was only 32.26 percent. The AO, therefore, made a transfer pricing adjustment on the basis of license fees paid in the immediately preceding assessment year (2002- 03). However, the AO agreed to the increased license fees for the last two months of the previous year 2002-03, and made an adjustment with respect to the license fees paid for the remaining 10 months (i.e. April 2002 to January 2003).

In appeal before the CIT (A), the Taxpayer made the following contentions:

• The Taxpayer had undertaken proper due diligence in determining the arm’s length price and therefore, neither the TNMM analysis performed nor the comparables selected by the Taxpayer could be arbitrarily rejected by the AO. In this context, the Taxpayer made reference to the decision of the ITAT in the case of Mentor Graphics (India) Pvt. Ltd. (109 ITD 101).
• Given the facts and circumstances of the case, the Taxpayer’s selection of comparables engaged in the distribution of software was justified;
• The AO’s use of the Taxpayer’s payments to NGC-Asia in respect of license fees for the previous year 2001- 02, for application of the comparable uncontrolled price (“CUP”) method was flawed as the same was not an uncontrolled transaction in the first place; and
• The observation of the AO that the subscriber base had stabilized was not correct because the subscriber base had almost doubled from five million in 2001 to ten million in 2003.
• The CIT (A) found merit in the arguments of the Taxpayer and turned down the order made by the AO based on the following observations:
• The AO, after rejecting the TNMM applied by the Taxpayer, had not made any suggestion as to which one of the five methods prescribed under rule 10B was to be applied. The AO appeared to have applied the CUP method using the Taxpayer’s own data from the previous year which could not be considered as an uncontrolled transaction;
• The same set of comparables as well as the method of computation of arm’s length price (in this case, TNMM), as adopted by the Taxpayer for the assessment year 2003-04, had already been accepted by the TPO in the subsequent assessment year, i.e. 2004-05; and
• The AO had already accepted the increased license fees for the last two months of the previous year 2002- 03 to be at arm’s length, but had not accepted the revised fees with retrospective effect. Besides, the decision to increase the license fees and the date from which such increase would be effective was a commercial decision which had not been examined by the AO properly.

Ruling of the Tribunal

Being aggrieved with the order of the CIT (A), the Department filed an appeal before the Tribunal. Judging the relative merit of the arguments made by the Department and the Taxpayer, the Tribunal held the following:

• Since the same set of com parables and the same method of computation of arm’s length price, as adopted by the Taxpayer for assessment year 2003-04, had already been accepted by the TPO for the subsequent assessment year 2004-05, such com parables and methodology have to be adopted for the purpose of computation of transfer pricing adjustments for assessment year 2003-04 as well. However, in its analysis, the Taxpayer had used comparable companies’ data pertaining to assessment year 2002-03, since at the time of undertaking the study, more recent data were not available for such com parables. Where the Taxpayer’s international transactions during the assessment year 2003-04 are being examined, it is most appropriate to use data for com parables over the corresponding period to demonstrate the arm’s length nature of such transactions, provided comparable companies’ data for the same assessment year (2003-04) are available.
• In case the computation of transfer pricing adjustment, if any, is to be made based on figures for the assessment year 2002-03, the Taxpayer’s transactions with NGC-Asia during that period can serve as basis for application of the CUP method, especially where such prior year’s transactions have already been accepted to be at arm’s length. The nature of the business remaining the same, such a comparison would yield better results, and cannot be rejected merely because the selected comparable transactions were not uncontrolled in the first place, particularly when such transactions had already been accepted to be at arm’s length.

In light of its observations, the Tribunal set aside the order of the CIT (A), and restored the case to the file of AO for re-working the transfer pricing adjustment using the TNMM, on the basis of facts and figures available for assessment year 2003-04 in respect of the com parables selected by the Taxpayer and already agreed to by the TPO for the subsequent assessment year 2004-05.

Conclusion

The ruling of the Tribunal affirms that in order to demonstrate the arm’s length nature of an assessee’s intra- group transactions for a particular assessment year, it is most appropriate to compare such transactions with data available for the same year in respect of comparables that have already been accepted by the Department. Also, where prior year data is being used for the purpose of a transfer pricing analysis and the nature of the business has remained the same, an assessee’s international transactions with associated enterprises during such prior years, can be used as internal comparables for application of the CUP method, provided such prior year’s transactions have already been accepted by the Department to be at arm’s length.