Significant Ruling by Mumbai Tribunal on use of filters for service companies

 

In an important ruling in the case of Capgemini India Private Limited (“CIPL”), the Mumbai Bench of the Tribunal has laid out important principles concerning benchmarking under the Transaction Net Margin Method (“TNMM”).

Brief facts

CIPL, a captive software development service provider to its associated enterprises had annual revenue of INR 5 billion in financial year 2006-07. It benchmarked its transactions using TNMM and identified four comparable companies including technology giants such as Infosys Technologies Limited (annual revenue of 130 billion) and Wipro Limited (annual revenue of
INR 100 billion). The Transfer Pricing Officer (“TPO”) added two more comparables during the audit proceedings and determined the Arms Length Price (“ALP”), which resulted in a Transfer Pricing adjustment. Further, the TPO rejected exclusion of one‑time Employee Stock Option Plan (“ESOP”) expenditure that was claimed as inoperative costs in computing the taxpayer’s margins. It also did not grant adjustment for differences in working capital levels. The Dispute Resolution Panel (“DRP”) rejected the taxpayer’s objections against the TPO’s order and did not also consider the additional comparables furnished by the taxpayer during the proceedings.

Issues

In this background, the taxpayer approached the Tribunal on the following issues

· Can Infosys and Wipro, who have very high turnover, be considered as comparables?

· Can comparables be rejected on the basis that it has high related party transactions (“RPT”) in standalone financial statements when margins could be computed from consolidated financial statements?

· Can one time ESOP expenditure be considered as operating cost?

· Grant of working capital adjustment as claimed by the taxpayer

Taxpayer’s contentions

· Comparability of Infosys and Wipro with the taxpayer: The taxpayer contended that it should be excluded as these companies, with very high turnover enjoyed economies of scale and had a better bargaining power. It referred to Dun and Bradstreet survey report which had categorized companies with a turnover of INR 2 to 20 billion separately from companies with a turnover of more than INR 20 billion.

· Use of consolidated financials of comparables: The taxpayer contended against rejection of consolidated financial statements and argued that stand alone financial statements reflected the consolidated results in cases where companies operated through branches in the foreign jurisdictions. The taxpayer also contended that selection of comparables should not be impacted where the companies chose to operate internationally through subsidiaries or branches.

· The taxpayer contended that ESOP charged to financial statement was one-time and extraordinary and should be excluded from costs while computing the operating margin for benchmarking purposes. It also claimed that working capital adjustment should be granted.

Revenue’s contentions

· Comparability of Infosys and Wipro: The Revenue submitted before the Tribunal a graphical relationship between the margins and the turnover for the comparables and contended that there was no linear relationship between them. The Revenue further contended that the economies of scale were not relevant for service providers.

· Use of consolidated financials: The Revenue contended that consolidated results which have profits from operations in different geographies cannot be treated as comparables.

· As regards ESOP, Revenue contended that the rules provide for adjustments only in case of comparables and that there was no provision for making adjustments to the margins of the taxpayer. It further contended that the working capital adjustment should not be granted as it was not claimed as part of Transfer Pricing documentation.

Decision of the Tribunal

· Comparability of Infosys and Wipro: The Tribunal ruled that unlike manufacturing companies who employ significant fixed assets, concept of economies of scale was not relevant to service providers. It also noted that the profit margins of software companies did not have any linear relationship to turnover. On the plea that Infosys and Wipro enjoyed better bargaining power, the Tribunal held that the taxpayer was ranked as amongst top 50 global software companies and being part of a large multinational group, it also enjoyed better bargaining power. Further, the Tribunal observed that only high turnover companies cannot be said to have high skilled employees. Further, high skilled employees would result in high employee costs and accordingly it noted that the margins would remain unaffected. It also held that the Dun and Bradstreet categorization was only on the basis of turnover and in the absence of empirical evidence that margins earned are related to turnover levels, such categorization could not be accepted. Accordingly, it rejected the argument that a higher turnover filter should be applied in the case of software companies.

· Exclusion of companies with turnover less than INR 1 billion: The Tribunal further held that turnover would be relevant only for the limited purpose of determining if the comparable selected is an established player capable of executing all types of work relating to software development, as compared to CIPL, which it considered was an established player. It held that the comparables should have a critical mass to compete successfully in the market, which can be decided by minimum quantum of work it must have done. Accordingly, the Tribunal held that additional comparables furnished by the taxpayer before the DRP, which had a turnover of INR 1 billion could not be treated as established players and had to be rejected.

· Use of consolidated financials: The Tribunal upheld Revenue’s contention that the consolidated financials include profits from different geographical and marketing conditions and observed that the taxpayer has not made any additional submissions to demonstrate that the comparable companies have branches abroad in addition to subsidiaries. Accordingly, it rejected the taxpayers claim for using consolidated financial statements to eliminate the impact of RPT in standalone financial statements.

· On the exclusion of ESOP expenses, it held that the charge is extraordinary, which had to be excluded in computing the taxpayer’s margins. As regards the claim for working capital adjustment, it held that the adjustment cannot be denied to the taxpayer only on the ground that it was not claimed in the Transfer Pricing study and noted that such adjustments had to be allowed as it improved comparability.