Delhi ITAT: For the purpose of transfer pricing analysis different STP units of a taxpayer should not be analysed on a standalone basis

In its recent judgment dated June 17, 2011 in case of ACIT vs. Birla Soft Ltd. [IT Appeal No. 4001 (Delhi) 2009] Hon’ble Delhi Bench of the Income-tax Appellate Tribunal (‘Delhi ITAT’) observed that it would be wrong to consider different STP units of the taxpayer on a standalone basis, for the purpose of transfer pricing analysis, wherein the services provided by the units are same/similar and to same Associated Enterprises (‘AEs’). Further, Delhi ITAT also observed that current year data of an uncontrolled transaction is to be used for the purpose of comparability, while examining the international transactions with AEs.

Facts

Birla Soft Ltd. (‘Taxpayer’) is the wholly owned subsidiary of Birla Soft Enterprises, which is further  owned by  Birla Soft Inc. US. It is engaged in the business of software development and related services. The software related business was being carried out from Software Technology Park (‘STP’). For the purpose of computation of arm’s length price, the taxpayer selected transactional net margin method (‘TNMM’) as the most appropriate method and justified the net margin earned on an operating cost (‘NCP’) on a company wide basis vis-à-vis margin earned by 24 comparable companies.

During the course of assessment, the assessing officer referred the case to the transfer pricing officer (‘TPO’) for computation of arm’s length price. The TPO;

·         rejected the company wide approach of the taxpayer and in-turn compared the profitability of each STP units on a standalone basis with the mean margin of comparable companies.

·         Out of 24 comparable companies selected by the taxpayer, the TPO rejected 9 companies.

·         Further, instead of multiple/ prior years data used by the taxpayer of comparable companies, the TPO only used current year data.

As out of 3, 2 STP Units were having lower NCP than the mean NCP of comparable companies, the TPO suggested transfer pricing addition.

The case travelled to Commissioner of Income-tax (Appeals) (‘CIT(A)’) and it disapproved the STP units on a standalone approach of the TPO. [The judgment is silent on stand of CIT(A) on comparable companies and usage of multiple/ prior years data].

Against the order of CIT(A), the Tax Department/ TPO filed an appeal before Delhi ITAT. The couple of transfer pricing issues which were raised before Hon’ble Delhi ITAT in this case were;

·         Whether the multiple year data used by the tax payer precedes the current year data used by the tax authorities?

·         Should each STP unit be considered as the standalone unit for computing ALP or the result of all the STP units has to be considered in totality?

Observation of Delhi ITAT – STP Units on a standalone basis

Hon’ble Delhi ITAT observed that there is no significant functional difference in the software development and maintenance services to related and unrelated parties. The services rendered by the STP Unit were rendered to the same AEs of, namely, Birla Soft Inc. US and Birla Soft UK on continuing basis. The terms and conditions for rendering such services by each of the STP Unit was governed by one single agreement entered into between Birla Soft India and Birla Soft Inc. US. The learned TPO assumed that functions, assets and risks (‘FAR’) undertaken by each of the STP Unit are distinct from each other and is comparable with the functions, assets and risks undertaken by existing comparables. In other words, learned TPO totally ignored the unity of the business, administrative control and unity of funds etc. The independent FAR analysis of each unit with existing comparables is practically not possible because there is a common management, interlacing of the funds etc.

Based on the above findings, Delhi ITAT held that the different STP Unites should not be benchmarked on a standalone basis.

Observation of Delhi ITAT – Usage of Multiple / Prior years data

Hon’ble Delhi ITAT observed that the usage of word ‘shall’ in the Rule 10B(4) makes it mandatory to first use the current year data and the proviso appended to the main section carves out an exception that the data relating to maximum two years prior to the current year may be considered, if the circumstances reveal an influence on the determination of transfer prices in the current year.

Rule 10B(4) of the Income-tax Rules

“(4) The data to be used in analysing the comparability of an uncontrolled transaction with an international transaction shall be the data relating to the financial year in which the international transaction has been entered into :

Provided that data relating to a period not being more than two years prior to such financial year may also be considered if such data reveals facts which could have an influence on the determination of transfer prices in relation to the transactions being compared.”

In this case, as the taxpayer was not able to demonstrate the influence of multiple/ prior year’s data on the determination of transfer prices in the current year, the view of the TPO was upheld.

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Chennai ITAT: Domestic PLR is not a comparable interest rate for loan given in foreign currency

Judgment dated May 20, 2011 of Hon'ble Income-tax Appellate Tribunal (‘ITAT’) in case of Siva Industries & Holdings Ltd. vs. Assistant Commissioner of Income-tax [IT Appeal No.2148 (MDS) of 2010] provides bit of guidance on justification of arm’s length rate of interest (‘ALP’) for a loan given by an Indian Company to its Foreign Subsidiary.

Facts of the Case

The tax payer, Siva Industries, has granted a loan to its subsidiary company in Mauritius for the purpose of making investment and had charged 6% interest p.a. the tax payer took average of 12 month’s US $ denominated LIBOR rate for the said period for the purpose of computing the ALP.

The tax authorities contended that the said rate cannot be taken for computing ALP since the loan was given from India and hence Prime Lending Rate (PLR) in India at that time should be considered and accordingly determined 11.75% p.a as the rate for computing the ALP and made the addition consequently.

Observation of the ITAT

The ITAT observed that as the loan provided to subsidiary company in Mauritius was out of its own funds and in foreign currency, the transaction would have to be looked upon by applying commercial principles in regard to international transaction. If that was so, then the domestic PLR would have no applicability. Further, the Hon’ble ITAT has also observed that as the rate charged by the taxpayer is more than mean LIBOR for a year, the LIBOR charged by the taxpayer from its subsidiary company in Mauritius is at arm’s length.

Our Comments

We feel though this judgment would provide relief to the taxpayers but it should give worry to the tax authorities. From a technical perspective it is correct to say that domestic PLR should not be considered comparable interest rate for the foreign currency loan however it may not be correct to say that LIBOR can be considered as comparable interest rate.

We understand that LIBOR is an interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. The LIBOR is fixed on a daily basis by the British Bankers' Association. The LIBOR is derived from a filtered average of the world's most creditworthy banks' interbank deposit rates for larger loans with maturities between overnight and one full year.

The LIBOR is the world's most widely used benchmark for short-term interest rates. It's important because it is the rate at which the world's most preferred borrowers are able to borrow money. It is also the rate upon which rates for less preferred borrowers are based. For example, a multinational corporation with a very good credit rating may be able to borrow money for one year at LIBOR plus four or five points. 

(Source: http://www.investopedia.com/terms/l/libor.asp)

We feel the correct approach would be to consider LIBOR as a base rate and then adjustment should be carried out based on the credit worthiness of the borrower and other commercial factors like time period, security, purpose etc.

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Please feel free to contact us for transfer pricing services like transfer pricing documentation assistance, transfer pricing control framework, transfer pricing planning, transfer pricing litigation etc.

Best Regards

Gaurav Garg

JGarg Economic Advisors

E: gaurav@jgarg.com

M: +91 98999 94934

JGarg: Your Transfer Pricing Partner