Introduction :

DURING the year 2001, guided by the international tax models, with a view to expanding the tax base, the Government brought in new provisions in Chapter X under the heading - Special Provisions Relating to Avoidance of Income Tax - commonly referred to as Transfer Pricing (TP) provisions. The main purpose of this new enactment was to determine Arms Length Price (ALP) in international transactions entered between associated enterprises (related parties). This new enactment changed the income tax landscape in India thoroughly, as it allowed the income tax department to garner more and more revenue in large measure, by expanding the scope to the maximum extent by covering all transactions without making any distinction between capital or revenue transactions. This unexpected move created a plethora of problems for the assessees who were hitherto paying more attention only to revenue transactions entered into with related parties and ensuring that the price charged either for their products or services is closer to the market price. The new thrust exhibited by the department to scrutinise all transactions, that too, by a specialised Transfer Pricing Officer (TPO) created a multitude of problems for the assessees and their advisers, who in turn were forced to engage in high cost litigation, seeking clear judicial verdicts - which also was not forth coming in full measure till date to their rescue. With a pre-deposit to the extent of 20% of the disputed demand required to fight further appeal before Commissioner of Income Tax (Appeals), the ordeal faced by the assessees became worse. Many times, the assessees also feel let down as timely verdicts are not handed and on many occasions, raging controversies are not decided but sidestepped, leaving the assessees to rue their fate.

In this short article, a snapshot of a new controversy that erupted recently in the TP arena is highlighted along with some other well-known disputes that are engaging the parties as of date are indicated. To give a wholesome thrust to the subject, a background to the TP law and the relevant procedures are also given. The discussion here will be confined only to TP in relation to international transactions and not with reference to domestic transfer pricing issues.

Some measures taken by government to streamline the TP proceedings:

Those who are curious to know the new subject of TP are invited to look at the shortest sentence written in an enactment which is the root cause for all these problems. This section is extracted below:

Sec 92(1) - Any income arising from an international transaction shall be computed having regard to arms length price…

A reading of the section normally should not yield to any ambiguity for any of the parties affected. But for assessees, their main grievance begins at the very first word - 'Any income…' which according to them is not understood by the Department at all, when they find to their surprise many transactions which had no income character are deliberately misconstrued by the Department and TP additions are made.

Without elaborating on the above, let us look at the steps taken by the Government while providing for detailed safeguards in the statute itself so as to not to unduly burden the assessees. Some of these are - (given in a summary form, that too only relevant to the topic)

(i) Every person, who has entered into an International transaction is required to obtain a report duly signed by an accountant in a prescribed form, justifying the price adopted by the assessee and submit it along with his return of income on or before 30th November of every year. This time limit is extended for assessees who have to submit the TP report up to November so as to enable them to access current year data of the comparable companies which could be used as a benchmark to justify the charging of the price by the assessees.

(ii) The Assessing Officer having jurisdiction over the case, while embarking on the assessment proceedings, makes a reference of the above report to the TPO asking him to look at the computation of ALP furnished by the asessee.

(iii) The TPO after scrutinising the report and other explanations offered by the assessee, determines the ALP in writing and forward a copy of his order both to the AO as well as to the assessee.

(iv) In cases where there is a variation made to the ALP by the TPO, the AO first prepares a draft assessment order and asks the assessee to file his objections If any. If the assessee objects to the proposed variations to the ALP, then he can take the matter to the Dispute Resolution Panel (DRP) which in turn will adjudicate all matters within a period of 180 days after allowing a hearing and providing an opportunity to the assessee to explain his views on the proposed additions. The assessee also has an alternative remedy of filing an appeal straight away to the CIT(A) and try his luck there (this topic is not discussed further here).

(v) The DRP's final order passed is adopted by the AO and he in turn will include the same as part of his assessment order. This order can be contested by the Assessee before the Income Tax Appellate Tribunal (ITAT), in case he is not satisfied about the additions made in the assessment.

(vi) The advantage for the assessees of taking the case before the DRP is that they get extra time of 180 days to conserve the probable cash outflow of tax which normally they would have paid upon completion of assessment, that too within 30 days.

(vii) As a part of the new enactment, even the time limit fixed under the Act for the completion of assessment is extended by 12 months.

(viii) Section 92C also provides for any of the 6 methods to be used to determine the ALP: These are - (i) Comparable Uncontrolled Price (CUP) (ii) Resale Price Method (RPM) (iii) Cost Plus Method (CPM) (iv) Profit Split Method (PSM) (v) Transactional Net Margin Method (TNMM) and (vi) such other method as may be appropriate. Detailed steps are also indicated in the Rules enacted in this behalf - see Rules 10A, 10AB, 10B, 10C, 10CA.

(ix) Additionally, there is a variation percentage of 3% on the price adopted by the assessee as the ALP - with that adopted by the AO - which is allowed.

(x) The Act also allows the CBDT to make Safe Harbour Rules (the minimum price expected to be charged in respect of certain transactions) and also the registration of Advance Pricing Arrangements (APAs) valid for a period of 5 years with the parties for determining the ALP.

Few examples of raging controversies:

Despite all the above procedures enacted in great detail, almost every TP proceeding leads to a protracted litigation. Some of the controversies that are pending in the Courts are:

- Selection of comparables (group of entities comprised in a homogeneous group)

- Choosing the appropriate method (out of 6 methods prescribed in the Income Tax Rules)

- Incurring of Advertisement and Marketing Expenses (AMP) by the Indian Associate Enterprise (AE) which is misconstrued as incurred on behalf of the foreign AE

The Karnataka HC in the case of Soft Brands (406ITR 513), held that picking of comparables for TP adjustments, applying of filters, etc do not give rise to any substantial question of law. On the other hand, in a series of decisions Delhi HC has looked at many aspects of the TP law including the selection of comparable companies, whether outstanding dues from the customers constitute an international transaction, the application of various methods to determine ALP etc. and rendered elaborate judgments.

Prelude to the present controversy:

One of the methods which is used to determine the ALP by most assessees, especially in the case of software and IT enabled services is the Transactional Net Margin Method (TNMM). To appreciate the present controversy, one should know about the TNM method. Hence some background information is given below about this method.

1. This requires comparison between net margins from the operations of the controlled entities and net margins derived by an AE from similar operations (selection of comparables)

2. Net margin is indicated by determining rate of return on sales or cost or operating assets (profit level indicator or PLI)

3. Functional analysis of the independent entity and the comparables is to be made to determine whether the transactions between the entities are comparable

Steps involved: (short summary of the Rules)

1. Search of comparable companies (to be properly documented): Margins earned by these Companies are benchmarked to the margin earned by the assessee from the international transaction.

2. Functions performed, assets employed, risks assumed (FAR) test: This involves identification of differences between the international transaction and the uncontrolled transactions

3. Finally, details of adjustments if any made to the price charged by the assessee in accordance with the ALP determined under the Rules.

Working Capital adjustment to determine Net margin:

As indicated above, a great deal of effort has to be made to identify the correct comparable companies, the margins of which could be benchmarked with that of the international transaction entered into by an asssesee. The next step involved is to work out the operating margins of each of these companies and arrive at the mean average. While carrying out this process, many times it is noticed that some companies have no borrowings at all, or, even these companies have negative working capital - meaning thereby that the entire funding requirements too are taken care of by the AE, many a times the parent company itself. In these cases, the question arises whether to achieve uniformity in comparison, a negative working capital adjustment has to made to determine the correct operating margin to be applied in the assessee's case.

(Working capital here is with reference to the capital required to fund the operations for short period of time - say during the completion of operations in a working capital cycle. For instance, in certain Industries, there is always significant cash collection but suppliers are paid after 30 days or so which results in negative working capital).

Bangalore ITAT Decision in - Tivo Tech Private limited - ITAT(Bang) decided on 12-06-2020

A recent case decided by the Hon'ble Bangalore Bench throws light on this issue. The facts of the case are:

1. The assessee is a captive software development company i.e. exclusively catering to its parent company in USA. The assessee is a wholly owned subsidiary of the parent company.

2. The dispute arose in the case for the Ay 2013-14 when the AO made a TP adjustment of Rs. 57 lacs (approx.) which was subsequently enhance to Rs. 79 lacs by the DRP.

3. It was agreed between the parties that TNM Method is the most suitable method to be adopted for determining the ALP.

4. The assessee's financials revealed the following:

The assessee, based on 11 comparable companies' data and after working out the arithmetical mean contended that the average profit margin of the comparable companies is only 12.45% whereas its profit margin is higher. Accordingly, no ALP adjustment is called for in its case.

5. The TPO accepted only 2 companies out of the 10 selected by the assessee as comparable companies and added 5 more companies as comparables and arrived at the arithmetical mean of 20.90%. Thereafter, the TPO added a working capital adjustment to each company's operating profit and arrived at a revised mean of 25.15 %.

6. On the above basis, the Computation of ALP was done by the TPO as under:

Issue: Whether negative working capital adjustment is to be done?

Assesse's arguments:

1. Working capital adjustment is made for the time value of money lost when credit period is given to customers. However, in this case the assessee is a captive unit which is entirely funded by the AE. The assessee has no borrowings and is fully compensated by the parent on a total cost plus. The assessee has no working capital risk - in other words, it is a risk-insulated service provider to the parent. The only customer of the company is its parent company.

2. The assessee relied on a host of ITAT decisions, the main decision being Adaptec (India) Private Limited, Hyd ITAT - decided on 25-03-2015 which was relied upon by the Hon'ble Bangalore ITAT in other similar cases and contended that no negative working capital adjustment is called for.

The Hon'ble Bangalore ITAT, after considering the similarity in facts of the assessee's case with that of the facts in the ITAT decisions referred above, deleted the negative working capital adjustment. Thus the working of the assessee of the ALP was accepted.

In the author's view, this is the correct approach as one has to look at the costs incurred by the assessee only and should not impute any additional cost as done by TPO, which indirectly enhances the ALP artificially. The ITAT also chose not to look at the dispute regarding the comparable companies to be reckoned for the purpose of determining ALP as the decision rendered by it directing that no working capital adjustment need to be made in these type of cases itself brought the new ALP computed by the TPO within the 3% margin level as permitted under the Act.

Contrary view as culled out from various views expressed by others, justifying the negative working capital adjustment:

1. Working capital adjustment is required in all cases as any credit extended to customers will result in cash locked up and will result in the assessee borrowing money from the banks and incur additional cost towards interest on these borrowings.

2. Price is normally related to market situation and remains more or less constant. Since under TNM method profit margins of comparable companies are analysed, it is better every company compared has same set of ingredients in the computation of operating margins - whether it has positive or negative working capital position.

3. Positive working capital adjustment is beneficial to the tax payer whereas negative working capital adjustment is beneficial to the revenue.

Delhi HC's view on Rule 10 B:

If one looks for additional support in favour of the assessee's view, one may refer to the following decision of the Delhi HC - some relevant observations on the interpretation of Rule 10 B of the IT rules: - Li & Fung India Private Limited v CIT -361 ITR 85 (Del) is extracted below.

"Rule 10B(1)(e) does not enable consideration or imputation of cost incurred by third parties or unrelated enterprises to compute the net profit margin for the application of TNMM. In order to apply the TNMM, the assessee's net profit margin realised from international transaction is to be calculated only with relevance to costs incurred by it and not incurred by any other entity, either third party vendors or AE. Rule 10 B(1)(e) recognises that the net profit margin realised by an enterprise from an international transaction entered into with an AE is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise. It contemplates the determination of ALP with reference to the relevant factors (costs, assets, sales etc.) of the enterprise in question i.e. the assessee, as opposed to the AE or any other third party".

Conclusion:

Thus we have now over a dozen ITAT decisions following the HYD ITAT's view that no negative working capital adjustment is to be made in captive entities operating with full support by their parent AE. However the department is still not satisfied with this view and is now contesting this issue further subject to the monetary limit fixed by the government for filing further appeals before the High Courts. Here too, one may end up facing the same question again - whether any referable question of law will arise on the issue of adjustment of negative working capital adjustment? Well - the answer may be - NO, if one goes by the Kar HC decision rendered in Soft Brands case. That leads to the next related question - Will all the questions on this aspect end here? Only time will tell.

(S Ramanujam, CA & Views expressed are strictly personal.)