Transfer pricing judgment could have been bolder

DIRECT TAX

A five-member special bench of the Bangalore Income-tax Appellate Tribunal recently pronounced its ruling in the case of Aztec Software. The ruling discusses (rather than adjudicates) on several aspects of procedural and substantive law on transfer pricing.

India's transfer pricing legislative origin dates to 2001, necessitated by increasing globalisation of the Indian economy, and seeks to prevent income-shifting through creative pricing of intra-group transactions. Since the regulations are still in their incipient stages, the first ruling assumes significance and has become a focal point for laying down important principles.

The transfer pricing tax assessment experience for past three years has resulted in the revenue authorities adopting principles which are inconsistent with international norms and Organisation of economically developed (OECD) guidelines, viewed as most authoritative on the subject.

An added reason for the interest and anxiety comes in the backdrop of a flurry of transfer pricing related developments. The Mumbai Tribunal Ruling in Sony Entertainment's case created a flutter by holding that profits of a foreign enterprise could be taxed, even if its related enterprise was compensated at fair value. However, the Morgan Stanley ruling of the Apex Court has given the IT industry a reason to smile, as it addresses concerns of over-taxation and curtails India's ambition to pursue strict source- based rules of taxation.

The ruling has wide ranging implications for multinationals doing business in India though more on the procedural front. The ruling, affirming importance of principles of natural justice as laid down by Indian jurisprudence, holds that the revenue can neither arbitrarily determine the arm's length price (reference price for related party transaction) nor can it rely on material not disclosed to the taxpayer. At the same time, a revenue officer is empowered to closely scrutinise cross-border transactions, if they exceed the monetary limit.

At a more nuanced level, the tribunal has correctly rejected the revenue authority's plea for use of the industry average for judging and comparing arm's length nature of a transaction.

It observed that any industry average is based on multiplicity of transactions that are diversified in nature, quality and content.The tribunal emphasised upon the principle, 'Transfer price is not an exact science'.

Experts have welcomed the observation as it seeks to align Indian regulations to international principles. The ruling is also being viewed as pro"�taxpayer due to its strong refrain on arbitrary adjustments and ad-hocism.

The tribunal has taken a strict view on arbitrary adjustments without a nuanced comparison of transactions after taking into account their specific features and conditions.

The tribunal could have been bold on important principles raised by Aztec, some of which have been side stepped and others set aside. On a closer look, it appears that the tribunal has thrown open more questions than it has answered. It has not adopted a firm stand on the fundamental issue of the choice of most appropriate method to determine arm's length price.

The tribunal by exercising the option of remanding the case has made the revenue officer's job more onerous.

The tribunal without adequate reasoning has held that a set of ten companies is too small for benchmarking purposes.

Similarly, it has harped on the importance of making adjustments to free-market transactions before considering them for comparison, it has not deliberated on the means for doing so. The tribunal has observed that multiple-year data for comparison can be considered only under exceptional circumstances. It has not said what such situations are.

Given that the decision was given by a five-member special bench, other jurisdictional tribunals will have no option but to follow these. This could potentially mean that transfer pricing disputes would go to courts. It is also uncertain as to how many times the cases may shuttle between the officers and appellate authorities, before reaching finality. Adding to the taxpayer's misery is the burden to furnish information throughout the entire proceedings, until the arm's length price is finally determined.

Clearly, while the ruling has articulated its view on procedural issues, the substantive issues pertaining to determination of arm's length price have been side stepped. Transfer pricing is the only arm of tax, which has more or less consistent principles across jurisdictions.

A critical aspect that India needs to debate upon is the need to revisit and reinvent them, given international jurisprudence and authoritative dictates from the likes of OECD.

Many aspects on the tax payer's right to choose the transfer pricing methodology, use of multi-year data, onus of proof etc, are best left to the tax payer. It is an anomaly to assume that a transaction price not aligned to arm's length standard is solely motivated by tax considerations. These are well settled principles in countries where the legislation has matured and we should follow these.

I fear a flurry of transfer pricing controversies breaking into India unless the administration considers rushing the Advance Pricing Agreement (APA) legislation, which would lend certainty to the tax payer or issue a set of administrative guidelines to the revenue officers to facilitate assessments. The current situation could mean unproductive use of time and resources for the tax payers and the tax administration.

The author is a Partner with BMR & Associates and views expressed herein are personal.