Global Tax Alert (News from Transfer Pricing) | 17 March 2014
Special Bench of Mumbai Tribunal rules on approach to selection of comparable data
This Tax Alert summarizes a recent decision of the Special Bench of the Mumbai Income-tax Appellate Tribunal (SB) in the case ofMaersk Global Centres (India) Private Limited [Taxpayer] for financial year ended 31 March 2008 reported in TS-74-ITAT-2014 (Mum)-TP. The Taxpayer is a provider of information technology enabled services (ITeS) such as transaction processing, data entry and information technology (IT) services such as process support/ optimization and technical support services to its Associated Enterprises (AEs). The Taxpayer's transfer pricing (TP) documentation supported that its international transactions were at arm's length using the Transactional Net Margin Method (TNMM). The Transfer Pricing Officer (TPO) rejected the TP documentation and made an adjustment by treating the activities of the Taxpayer to be in the nature of Knowledge Process Outsourcing (KPO) services instead of Business Process Outsourcing (BPO) services.
The main issue before the SB was whether for purpose of comparability analysis, there is a requirement to further segregate ITeS into BPO and KPO services? The SB, while approving TNMM as the most appropriate method (MAM), and considering the gamut of services provided by companies in the ITeS sector, ruled that there is no requirement to further segregate ITeS into BPO and KPO activities. The SB also ruled that comparables having abnormally high profits need not be eliminated at the threshold, but should trigger further investigation to ascertain whether such trends reflect normal business conditions or not. Where a high profit margin making entity does not satisfy comparability criteria or the same does not reflect normal business conditions, then such entity needs to be excluded from the comparability analysis.
The Taxpayer, an Indian company, is part of the Maersk Group and is engaged in the provision of ITeS as well as IT services to its AEs. In the TP documentation for the financial year (FY) 2007-08, the Taxpayer selected comparables in the field of BPO to ascertain the arm's length price and concluded by applying TNMM as the MAM that its international transactions were at arm's length.
During audit proceedings, the TPO observed that the Taxpayer was operating with more than 2,000 employees out of a “state of art” facility and was providing services such as documentation, finance, operations, logistics, global information systems etc. The TPO noted that Taxpayer was largely rendering logistic outsourcing services and business analytic services, which involved transfer of knowledge intensive process and significant domain expertise. Accordingly, TPO classified the services as knowledge/expertise based and characterized the same as KPO services. The TPO rejected the Taxpayer's transfer pricing study and proceeded to re-determine arm's length price by conducting a search for fresh comparables and using appropriate filters made a TP adjustment. The TNMM was however accepted as the MAM.
The Taxpayer then filed objections with the Dispute Resolution Panel (DRP). The Taxpayer objected to its characterization as a KPO and also raised various other objections. The DRP directed the assessing officer (AO) to exclude a few companies and grant the benefit of an adjustment for differences in working capital. However, the DRP rejected the Taxpayer's argument on BPO vs. KPO and did not give relief on some of the other grounds. The Taxpayer thereafter filed an appeal before the Tribunal, the ultimate fact finding authority in the Indian dispute resolution framework, against the TP adjustment. As the Tribunal was of the view that the issue raised by the Taxpayer was contentious, the matter was referred to a SB.
Questions before the SB
The SB specifically decided on the following two questions:
- • Whether for the purposes of determining the arm's length price of international transactions of the Taxpayer providing back office support services to their overseas associated enterprises, companies performing KPO functions should be considered as comparable?
- • Whether, in the facts of the Taxpayer's case, companies earning abnormally high profit margins should be included in the list of comparable companies for the purposes of determining the arm's length price of an international transaction?
In adjudicating the matter, the SB has ruled on various important aspects relating to the Indian TP provisions. Some of the key observations of the SB are stated below.
Most appropriate method for ITeS sector
Indian TP rules provide the manner and circumstances in which different methods are to be applied for determining the arm's length price and also provides for factors governing selection of the MAM. Based on the facts and circumstances of each case, any of the prescribed methods can be regarded as the MAM.
Considering the peculiarities of the sector and in the facts of the case, the SB held that TNMM should be regarded as the MAM because in the TNMM, characteristics of property/ services is less sensitive while evaluating comparability, as it considers “net margin” realized. The SB also recognized that one of the strengths of TNMM is that “net profit” indicators (e.g., operating income) are less affected by transactional differences. TNMM affords a practical solution to otherwise insoluble transfer pricing problems, if used appropriately, and with adequate adjustments to account for differences.
Therefore, in the case of TNMM, broad functionality can be taken into consideration for selecting potential comparables. However, it does not mean that standard of comparability is diluted merely because the method followed is TNMM. Placing reliance on the Delhi High Court's decision in the case of Li and Fung India Pvt. Ltd reported in ITA No. 306 of 2012 and the OECD Transfer Pricing Guidelines (OECD TPG), the SB ruled that the standard of comparability for application of TNMM is no less than that for application of any other method.
Comparability analysis for ITeS sector
There are peculiar issues governing ITeS sector such as absence of relevant financial data in public domain. Accordingly, it is appropriate to find a practical solution that assists in performing comparability analysis for cases belonging to ITeS sector. This problem can be resolved by splitting the comparability exercise into two steps in order to attain relatively equal degree of comparability.
- • First step is to select potential comparables at ITeS sector level by applying “broad functionality” test. Thus, all entities providing ITeS can be taken as potential comparables. OECD TPG also indicates “broad-based analysis” as an essential step in comparability analysis and can be defined as an analysis of the industry, competition, economic and regulatory facts and other elements that affect taxpayers and their environment, but not looking at the specific transactions in question.
- • Subsequent step is to ascertain whether “bifurcation”/“classification” of ITeS are possible for rejecting/selecting comparables from the list of potential companies.
Indian transfer pricing rules permit exclusion of certain entities selected as potential comparables by applying a broad functional test at the micro level to attain a relatively equal degree of comparability. OECD TPG also advocates that uncontrolled transactions having a lesser degree of comparability be eliminated. Accordingly, “bifurcation”/“dissection” of ITeS can be done, depending on the facts and circumstances of each case, in order to select entities having a relatively equal degree of comparability.
“Bifurcation” of ITeS into BPO and KPO services
As further “bifurcation”/“classification” of ITeS may be required to bring in relatively equal degrees of comparability, a question that arises is whether such “bifurcation” can be done between BPO and KPO services so as to say that BPO services are not comparable with KPO services.
Referring to various industry reports submitted, the SB observed that BPO services are generally referred to as low end services, while KPO services are referred to as high end and thus, there exists some differences between the two. However, the range of services rendered by the ITeS sector is so wide that a classification of all services, either as low end or high end may not always be possible. One of the key success factors of the BPO industry is its ability to move up the value chain through KPO service offerings. While KPO is termed as an upward shift of the BPO industry and the evolution of the majority of Indian BPOs has given rise to KPO, in this process, BPOs trying to upgrade as KPO are likely to render both, BPO and KPO services, and such entity therefore, cannot be considered strictly either as a BPO or a KPO. Considering the nature of mixed services, it is difficult to classify them as BPO or KPO. Further, determination of the exact portion of BPO and KPO services may not be possible, and in such circumstances, it may not be possible to create a “third” alternative, which is somewhere in between BPO and KPO.
The Tribunal observed that there could exist significant overlap between ITeS activities with some activities being very fact sensitive. Therefore, introducing an artificial segregation within ITeS may create more problems in comparability analysis than resolving the same. Accordingly, it held that ITeS cannot be further bifurcated/ classified as BPO and KPO services for purposes of comparability analysis.
Whether Taxpayer qualifies as BPO or KPO service provider?
The SB held that a perusal of the functional profile of the Taxpayer indicated that services such as process support/optimization and technical support are not in the nature of low end services, as they require some degree of specialized knowledge and domain expertise. However, the revenue generated from such services was only about 10% of the total revenues generated by the taxpayer during the FY 2007-08.
The SB observed that the Taxpayer also rendered services such as contract drafting, audit functions based on different business strategies, tender handling etc. which cannot be, strictly considered as low-end services, as they involve some degree of special knowledge/ expertise. However, such services are “incidental” to the main services involving data entry, transcription, consolidation, co-ordination, preparation, processing and review of shipping documents and such other similar support services. Further, the profile of work-force employed comprised of 96% of graduates/ postgraduates whereas only 4% work-force was highly skilled professionals (such as chartered accountants), which indicates that functions performed were mainly in the nature of providing back office support services of a low-end nature.
The SB held that, considering the functional profile, the Taxpayer was only a captive contract service provider, mainly rendering back office support services. Some services may involve a certain degree of special knowledge/ expertise but those were only an insignificant portion of the total services performed and essentially in the nature of incidental services. Accordingly, SB ruled that potential comparables to be selected should also be low end service providers and not high end KPOs.
Using the above principle, the SB examined two companies namely Mold-Tek Technologies and Eclerx Services being disputed by the Taxpayer. The SB directed the exclusion of these two companies on the grounds of them being involved in providing high end services involving specialized knowledge and domain expertise in the field.
Exclusion of abnormally high profit margin companies
The SB observed that the Indian transfer pricing regulations specifically deviate from the OECD TPG, which provides for inter-quartile range of benchmark results that automatically excludes outliers compared with use of the arithmetic mean provided in the Indian regulations for determination of the arm's length price. It held that merely because a comparable has shown abnormal profits, the same cannot be grounds for its exclusion. Potential comparables earning abnormally high profit margins should trigger further investigation. This will help in ascertaining whether earning of high profit reflects a normal business condition or whether it is the result of some abnormal conditions prevailing in the relevant year. Further, the profit margin earned by such entity, in the immediately preceding year(s), may also be taken into consideration. The functional, asset and risk analysis in such cases may be reviewed to ensure that the potential comparable earning high profit satisfies comparability conditions. If it is found that the high profit margin making entity does not satisfy the comparability criteria, or the high profit margin earned by it does not reflect normal business condition, then such comparable should be excluded.
Globalization has led many multinational enterprises to establish information technology and back office operations in India. Such centers have faced significant TP controversy relating to comparability analysis. The process followed to identify potential comparables is an important aspect of the comparability analysis. The choice of selection criteria has a significant influence on the outcome of the analysis and should, therefore, reflect the most meaningful economic characteristics of the subject transactions. The approach adopted by the tax authority in selection of comparable data has generally been a contentious issue in most TP controversies.
The SB rejects a broad brush distinction between BPO and KPO services while undertaking a comparability analysis for provision of outsourced services. At the same time, the SB recognizes that a wide set of potential comparables that operate in the same sector of activity and perform similar broad functions may need to be further refined using qualitative criteria having regard to facts and circumstances. This ruling, with clear emphasis on the functional aspect of comparability analysis, provides guidance on a number of issues that taxpayers as well as tax authorities face while undertaking a TP analysis for such transactions, especially with regard to the approach in selection of comparable companies. The ruling also provides guidance on comparability considerations when potential comparables demonstrate abnormally high profit results.
Taxpayers should therefore appropriately consider the impact this ruling could have on their intercompany TP arrangements.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (India), Bangalore
- • Rajendra Nayak
+91 80 4027 5454
Ernst & Young LLP (India), New Delhi
- • Vijay Iyer
+91 11 6623 324
EYG no. CM4260