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Transfer Pricing- Supernormal profit making companies should be excluded from the comparable set

Delhi bench of the Income-tax Appellate Tribunal (the Tribunal) in the case of Adobe Systems India Private Limited v. ACIT [201 1-TII-13-ITAT-DEL-TP] (Date of Judgement: 21 January 2011; Assessment Year: 2006-07)held that supernormal profit making co

Delhi bench of the Income-tax Appellate Tribunal (the Tribunal) in the case of Adobe Systems India Private Limited Vs. ACIT [201 1-TII-13-ITAT-DEL-TP] (Date of Judgement: 21 January 2011; Assessment Year: 2006- 07) held that super normal profit making companies should be excluded from the comparable s set, as they have a tendency to skew the results and cannot be considered as representative of the industry. The Tribunal further commented that the order of the Dispute Resolution Panel (DRP) was very cursory and laconic contrary to the mandate of Section 144C.

Facts of the case

• The taxpayer, a wholly owned subsidiary of Adobe Systems Inc., USA, is engaged in provision of software development services and marketing support services to its associated enterprises, as a contract service provider.

• In the Transfer Pricing Documentation for assessment year (AY) 2006-07, the taxpayer has earned an operating margin (Operating Profit/ Total Cost) of 14.96%. The Transfer Pricing Officer (TPO) rejected the arm’s length analysis of the taxpayer and proceeded to determine the operating margin at 24.9 1% by removing certain com parables selected by the taxpayer and introducing some new com parables.

• Further, the TPO used the updated data for financial year (FY) 2005-06 instead of the weighted average of earlier years as relied upon by the taxpayer.

Taxpayer’s contention

> The taxpayer, placing reliance on the Tribunal judgment in the case of Mentor Graphics and OECD Transfer Pricing Guidelines, argued that out of the new comparables introduced by the TPO, three companies were super-normal profit making companies, which have a tendency to skew the results and are not representative of the industry.

> Moreover, the taxpayer had rejected two of these companies in its transfer pricing documentation as being functionally not comparable and the third company did not even appear in the taxpayer’s economic analysis.

> During the TP assessment proceedings, the taxpayer submitted detailed contentions in respect of each of these three com parables to substantiate that they were functionally not comparable and also one of the companies had substantial related party transactions.

> Based on the above, the taxpayer contended that these three companies should be rejected. By excluding these three com parables, the resultant operating margin of the com parables was within the 5% tolerance range as permitted under the proviso to Section 92C(2).

TPO’s arguments

> The TPO rejected the taxpayer’s contention of super normal profit in case of one company by stating that the company had shown consistently high growth in the preceding years also and hence, there was no abnormality in its performance. The TPO did not deal with the super normal profit aspect of the other two companies selected by the TPO.

> The TPO also rejected the taxpayer’s argument of related party transactions in case of one of the three companies selected by the TPO by stating that there was no information on the details of related party transactions in ‘Capitaline’ and ‘Prowess’ database and also in the annual report of that company.

Tribunal’s Ruling

The Tribunal ruled in favor of the taxpayer. The key aspects of Tribunal’s order are summarized below:

• The Tribunal observed that the TPO had rejected the taxpayer’s contention with regard to inclusion of the three super normal profit making companies without giving any cogent reasons.

• The Tribunal held that the taxpayer’s argument regarding exclusion of three super normal profit making companies was correct.

• The Tribunal also commented that the DRP had passed a very cursory and laconic order without going into the details of the voluminous submissions made by the taxpayer. The Tribunal found that this approach is contrary to provisions of the law though unlike other judgements by Tribunals on this issue, the Tribunal in this did not refer the matter back to the DRP.

Our Comments

The Tribunal’s view regarding exclusion of super profit making companies is consistent with the view expressed in the case of Mentor Graphics and other judgements. However, the Tribunal has not provided detailed reasons as to why super-normal profit making companies should be excluded.

NF
Categories: Income Tax
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