Landmark ruling on transfer pricing of
computer software: At an arm’s length

In an important ruling for the IT industry the ITAT has come out against arbitrary calculations in determining what constitutes an arm’s length price.

By Yatish Yadav

A recent decision of a two-member bench of the Income Tax Appellate Tribunal in Delhi in the case of Mentor Graphics (Noida) Private Limited will have important implications for the pricing of computer software developed by Indian firms for their foreign clients and the taxes they pay on their income. The decision is considered by accountants and lawyers to be a “landmark ruling on transfer pricing”.

First, the facts of the case. The company Mentor Graphics, which is a taxpayer, is a captive service provider rendering software development support and marketing systems services to its parent company located in the United States. Being a contract software development support service provider, the Indian company undertakes limited functions and risks. All intangibles including discoveries, improvement, inventions and trade secrets remain the sole and exclusive property of the parent company in the US. The Indian firm maintains and deploys human resources for software development. The software developed is used in-house by the parent company. The integrated software supports the computer hardware manufactured by the parent and is sold as a package in the market.

During the financial year 2001-02, Mentor Graphics used the transactional net margin method (TNMM) to demonstrate the “arm’s length” nature of the services rendered to its parent company. During income tax assessment proceedings, the Transfer Pricing Officer (TPO) made an adjustment to the income earned from provision of software services, while the provision of
marketing systems services was held to be at arm’s length. The adjustment made to income from rendering of software related services was upheld at the appellate level by the Commissioner, Appeals (Income Tax). The taxpayer, Mentor Grap-hics, appealed against the decision before the Income Tax Appellate Tribunal (henceforth, the Tribunal).

The primary dispute was in respect of the choice of comparables used for determining the arm’s length price. The Tribunal noted that the question of validity of reference to the TPO (based on an administrative circular) had already been settled in an earlier case (relating to another computer software firm called Aztec) in which the ruling had gone against the taxpayer.

Citing the decisions of the Supreme Court in the Aztec and Morgan Stanley cases, the Tribunal stressed the importance of a comprehensive FAR (Functions, Assets and Risks) analysis. The specific characteristics of the controlled transaction were also to be studied to ascertain whether it related to transfer of goods, services or intangibles. Thus, a mere consideration that a controlled transaction related to “software supply” was held to be insufficient, as there can be hundreds of software with different characteristics affecting their open market values.

While it is true that ‘transfer pricing’ is not an exact science in which approximation cannot be ruled out, it has nevertheless to be shown that the FAR analysis was ‘judicial’ and done after taking into account all the relevant facts and circumstances of the case.

Since comparable company data in relation to related party transactions was not available for the financial year 2001-02, during the assessment stage, the TPO relied on data on related-party transactions that was available for financial year 2003-04. The TPO then deduced that the company did not have related-party transactions in 2001-02. The Tribunal ruled that where data in respect of related-party transactions is not available for a particular comparison, it is appropriate to exclude such comparison’s than to be guided by data of a future year. Such inferences or presumptions were not authorized or acceptable.

While undertaking a comparability analysis, the Tribunal emphasized on the examination of the following factors:
> Size of the company
> Characteristics of the company and whether those companies have any intangible properties
> Ratio of fixed to operating assets
> Variation between profit level indicators of the different companies
> Assets employed to earn profit
> Risks due to human resources, infrastructure and quality
> Risks such as market risk, contract risk, credit risk, collection risk and risk of infringement of intellectual property rights.

As far as the last point is concerned, the Tribunal observed that these risks are not being taken into consideration in most of the comparable analyses carried out in India although this could lead to major differences in the market value of transactions. The factors mentioned are more detailed compared to those prescribed in the regulations:
> In respect of reliance on employee cost as a factor for exclusion of companies, the Tribunal held that since employee cost is low or similar throughout India, this is not a factor that would make a material difference.
> The Tribunal rejected companies with high profits and high losses as comparables. This was based on the view that the taxpayer did not own intangibles and operated in a no-risk environment.

The Tribunal, accepting that it is rare to locate identical uncontrolled transactions, held that the arm’s length price is to be determined by taking the result of a comparable transaction in comparable circumstances and by making suitable adjustments for the differences. Further, it has been clarified that wherever possible, adjustments for differences in working capital, risk and research and development (R&D) should be made. Where differences in risks are substantial, the comparables identified are not correct and should be filtered further as appropriate adjustments for differences in risk may not be possible.

Relying on the guidelines prepared by the Organization of Economic Cooperation and Development (OECD), the group of the most developed nations in the world, as well as Indian regulations, the Tribunal held that where TNMM method is applied to determine arm’s length price, the functional profile, assets and risks assumed in controlled and uncontrolled transactions need to be considered. The Tribunal ruled that while applying TNMM, the TPO cannot refuse to consider specific characteristics of transactions, functions performed and assets employed.
The Tribunal held that a wide difference in the ratio of operating margins for comparables is indicative of faulty selection of comparables. Relying on OECD Guidelines, the Tribunal observed that under such circumstances, the TPO was expected to undertake a further analysis and evaluate the selected comparables to see whether the variation was on account of FAR. (In the set of comparables finally selected by the TPO, the operating margins varied widely from 3.16 per cent to 37.89 per cent.) Following the decision of the Special Bench in the Aztec case, the Tribunal held that the arm’s length price has to be determined based on the current year data. On the issue of arm’s length range, the Tribunal has laid out the following principles:

The revenue authorities and the taxpayer can compute different arm’s length price using different methods. In such a situation, the mean of the arm’s length prices arrived at (using different methods) may be taken as the arm’s length price. The taxpayer can compute the arm’s length range, based on several arm’s length prices, as computed under a given method. As long as the taxpayer is able to demonstrate that the transfer price falls within the aforementioned range, the onus shifts to the revenue authorities to prove that such transactions are not at arm’s length. This, in the view of BMR Associates, a consulting firm of accountants, is a “liberal” interpretation of computation of arm’s length price.

On intervention by the TPO, the Tribunal also held that the TPO can undertake a fresh search only if the comparables drawn by the taxpayer were insufficient or had other deficiencies. Hence, once taxpayers undertake detailed documentation, their analysis cannot be arbitrarily rejected at the stage of audits, based on inferences and presumptions. The Tribunal has extensively quoted OECD guidelines and categorically stated that the TPO erred by not relying on either the Indian regulations or the OECD guidelines. The Tribunal also relied upon a 1979 US court ruling (EIDU Pont de Nemours & Co. vs. US) to illustrate how closely controlled and uncontrolled entities should be compared.

Further, it has drawn a contrast between the approach of the European tax authorities (in respect of adjustments) and the approach required under Indian regulations. European tax authorities are reluctant to accept ‘adjustments’ as they necessarily involve questions on how appropriate such adjustments have been. Thus, the tendency is to select comparables requiring least or no adjustment. By way of contrast, Indian regulations require that where there are differences, adjustments should be made and where adjustments for material differences are not possible, the comparables should be rejected. Based on five comparable companies, the Tribunal adjudged Mentor Graphics to be within the arm’s length range. It is pertinent to note that in the Aztec ruling, the Special Bench had held that ten comparables were not adequate. In conclusion, the Tribunal has dealt with comparability issues in detail addressing several nuances. It has encouraged the use of diagnostic ratios such as ratio of fixed to operating assets. Its observation that high profit or loss making companies should be ignored is an important statement that is in alignment with the OECD’s Draft Comparability Notes (that were released for public comment on May 10, 2006).
Generally speaking, there has been a tendency on the part of the taxpayer and the revenue authorities to apply the TNMM in a flexible manner without regard to tenets of comparability analysis. The Tribunal has emphasized that even where TNMM is applied, comparability principles should be paid due attention. Once again, the Indian Tribunal has reiterated the importance of OECD guidelines and American regulations/jurisprudence on transfer pricing.

In the context of determining what is an arm’s length range, although there is a direct reference only to the TNMM, it is debatable whether the same principle can be applied to other methods. In other words, the Tribunal has firmly stated that it is against any arbitrariness in determining what constitutes an arm’s length price.