2014 (3) TMI 891 - AT - Income Tax

Broad Functionality Test Applies to ITES Comparables; Exclude High-End KPO and High-Profit Entities Under Transfer Pricing Rules

ITAT Mumbai held that all entities providing IT-enabled services can be potential comparables under a broad functionality test, but further classification ... Transfer pricing adjustments - Selection of comparable - Whether a company performing KPO functions should be considered as comparable or not – providing back office support services to their overseas associated enterprises - Held that:- All the entities providing IT enabled services can be taken as potential comparables by applying a broad functionality test - further dissection or classification of ITES services can be done depending on the facts and circumstances of each case so as to select the entities having a relatively equal degree of comparability. Keeping in view the large number of services falling under ITES, the difficulty in classifying these services either as low end BPO services or high end KPO services, the difficulty in creating a third category of entities falling in between BPO and KPO and lesser degree of comparability even within BPO and KPO sector, we are of the view that the ITES services cannot be further bifurcated or classified as BPO and KPO services for the purpose of comparability analysis. If the assessee company, on the basis of its own functional profile, is found to have provided to its AE the low-end back office support services like voice or data processing services as a whole or substantially the whole, the companies providing mainly high-end services by using their specialized knowledge and domain expertise cannot be considered as comparables. If the functions actually performed by the assessee company for its AEs are compared with the functional profile of M/s eClerx Services Pvt. Ltd. and Mold-Tec Technologies Ltd., it is difficult to find out any relatively equal degree of comparability and the said entities cannot be taken as comparables for the purpose of determining ALP of the transactions of the assessee company with its AEs. We, therefore, direct that these two entities be excluded from the list of 10 comparables finally taken by the AO/TPO as per the direction of the DRP. Selection of comparable – Whether a company earning high profit margin to be included in the list of comparable – Held that:- the answer to this question will depend on the facts and circumstances of each case inasmuch as potential comparable earning abnormally high profit margin should trigger further investigation in order to establish whether it can be taken as comparable or not. Such investigation should be to ascertain as to 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. The profit margin earned by such entity in the immediately preceding year/s may also be taken into consideration to find out whether the high profit margin represents the normal business trend. If it is found on such investigation that the high margin profit making company does not satisfy the comparability analysis and or the high profit margin earned by it does not reflect the normal business condition, we are of the view that the high profit margin making entity should not be included in the list of comparable for the purpose of determining the arm's length price of an international transaction. Otherwise, the entity satisfying the comparability analysis with its high profit margin reflecting normal business condition should not be rejected solely on the basis of such abnormal high profit margin. - Decided partly in favour of Assessee. Issues Involved:1. Determining arm's length price (ALP) for international transactions involving IT enabled services (ITES) and IT services.2. Inclusion of companies performing Knowledge Process Outsourcing (KPO) functions as comparables.3. Inclusion of companies earning abnormally high profit margins as comparables.Detailed Analysis:1. Determining ALP for International Transactions Involving ITES and IT Services:The assessee, a wholly-owned subsidiary of Maersk GSC Holdings A/S, provided IT enabled services and IT services to its associated enterprises (AEs). The ALP of these transactions was determined using the Transactional Net Margin Method (TNMM) with the operating profit to total cost (OP/TC) as the Profit Level Indicator (PLI). The TPO found defects in the TP study report submitted by the assessee and rejected it. The TPO re-characterized the services provided by the assessee as Knowledge Process Outsourcing (KPO) services, rejecting the majority of the comparables selected by the assessee and selecting new ones. The DRP partly accepted the objections raised by the assessee and directed the inclusion of some comparables initially selected by the assessee.2. Inclusion of Companies Performing KPO Functions as Comparables:The primary issue was whether companies performing KPO functions should be considered comparable to the assessee, which provided back-office support services. The Tribunal held that the comparability of international transactions with uncontrolled transactions should be judged with reference to functions performed, taking into account assets employed and risks assumed. It was concluded that the ITES sector cannot be further bifurcated into BPO and KPO services for comparability analysis. However, if the assessee provides low-end back-office support services, companies providing high-end KPO services cannot be considered comparable. In the present case, the Tribunal found that the assessee was mainly providing low-end back-office support services, and therefore, companies like Mold-Tek Technologies Ltd. and eClerx Services Ltd., which provide high-end KPO services, were excluded from the list of comparables.3. Inclusion of Companies Earning Abnormally High Profit Margins as Comparables:The Tribunal addressed whether companies earning abnormally high profit margins should be included in the list of comparables. It was held that high-profit margin entities should trigger further investigation to understand the reasons for such high profits. If high profits are due to normal business conditions and the entity satisfies the comparability analysis, it should not be excluded solely on the basis of high profit margins. However, if the high profits are due to abnormal conditions, the entity should be excluded from the list of comparables. The Tribunal noted that the Indian TP regulations specify the arithmetic mean for determining the ALP, which includes extreme values, unlike the quartile method suggested in the OECD guidelines.Conclusion:The Tribunal directed the AO to recompute the ALP by excluding Mold-Tek Technologies Ltd. and eClerx Services Ltd. from the list of comparables. If the difference between the recomputed ALP and the price charged by the assessee is within the safe harbor limit of +/-5%, no TP adjustment should be made. The Tribunal also provided guidelines for further investigation in cases of entities with abnormally high profits to determine their inclusion in the list of comparables.