Sharing insights Tribunal upholds important transfer pricing principles on characterisation and rewards for selling activity In brief Facts

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1 Sharing insights News Alert 1 March, 2012 Tribunal upholds important transfer pricing principles on characterisation and rewards for selling activity In brief In a recent ruling in the case of Mastek Ltd 1. (the taxpayer), the Ahmedabad Bench of the Income-tax Appellate Tribunal (the Tribunal) concluded that the taxpayer's UK subsidiary was not merely undertaking marketing activities. The Tribunal held that the UK subsidiary should be characterised as a distributor on the basis of its agreement with the taxpayer, selling efforts, market and credit risks and overall business strategies. Furthermore, the Tribunal held that the reward has to be 1 Mastek Ltd. v. ACIT [ITA. No. 3120/Ahd/2010] determined with regard to return on sales rather than a mark-up on value added expenses (marketing and selling expenses). Facts The taxpayer is a global software solutions provider and provides offshore and onsite solutions to clients. The taxpayer operated through overseas subsidiaries in various countries. The taxpayer had a subsidiary in the UK, Mastek (UK) Ltd. (MUK) which contributed more than 60% of the revenue during the year under consideration. 1

2 MUK acted as a distributor for the software solutions of the taxpayer in the UK and earned a return on sales (operating margins). In its transfer pricing (TP) documentation, the taxpayer selected MUK as the tested party and benchmarked the return on sales with comparable distributors. During the course of assessment proceedings, the transfer pricing officer (TPO) recharacterised MUK as a pure marketing service provider by stating that the functions of MUK were purely marketing activities and MUK did not bear any inventory, foreign exchange and profit risk. The TPO accordingly considered comparable marketing service providers and applied their operating profit/value added expenses (OP/VAE) to MUK s VAE and computed a TP adjustment. The Dispute Resolution Panel (DRP) upheld the order of the TPO. Aggrieved, the taxpayer appealed before the Tribunal. Revenue s contentions Before the Tribunal, the Revenue contended that MUK s functions of identifying customers, establishing contacts, soliciting enquiries, managing customer relationships, advertising and sales promotion, negotiation and signing of contracts, and agreeing the scope and timing of the deliverables were nothing but front office or marketing activities. Furthermore, MUK cannot conclude contracts, fix prices or time of delivery on their own without help from the taxpayer. Also, MUK had no brand/technical expertise to distribute the taxpayer s services. MUK did not bear risks relating to inventory, foreign exchange and profits. The market risk, service liability risk, technology risk, credit risk, man-power risk and foreign exchange risk remained with the taxpayer. Since MUK earned a fixed percentage of return on sales as per the agreement with the taxpayer, MUK had not functioned like an independent distribution company who would have earned a fluctuating profit. The TP analysis conducted by the taxpayer was defective since the comparables identified were engaged in distribution of software products. Since MUK is merely a marketing services provider, appropriate comparables should be companies engaged in similar activities and their margin on costs should be applied to the VAE of MUK. Taxpayer s contentions Before the Tribunal, the taxpayer contended the following The taxpayer and MUK had entered into a legally binding distribution agreement which discussed the roles and responsibilities of the parties and provided that the relationship between MUK and the taxpayer was on a principal-to-principal basis. MUK undertook key selling activities which included negotiating and concluding contracts which were value added functions beyond marketing and front office activities. MUK employed qualified managerial and technical personnel and provided details of the sales team organisation structure, designation, qualification and roles. Activities that MUK undertook as part of the selling function alongwith specific client case studies depicting complexities in selling activities were explained. Furthermore, the taxpayer explained that employees of MUK were incentivised in the form of commission on sales generated. Further, MUK had customer relationships and contracts. Given the selling functions, MUK should be characterised as a distributor and not a mere marketing services provider, a cost-plus method (CPM) is not an appropriate reward mechanism for a distributor. 2

3 Reliance was placed by the taxpayer inter alia on the ruling of the Kolkata Tribunal in the case of Development Consultants Pvt. Ltd 2, which recognised the characterisation of the distribution of services as well as guidance provided by the UK HMRC 3 which provided that a CPM is not likely to be appropriate for selling activities. The commercial perspective of the taxpayer s business model also needed to be considered. The taxpayer was enjoying tax holiday under domestic tax law and there was no reason for the taxpayer to shift its profit outside when the income from MUK would have taxable in UK at 30%. Tribunal ruling After considering the rival contentions, the Tribunal entirely upheld the taxpayer s contentions on the basis of the following: Agreements between parties based on commercial expediency cannot be disregarded without assigning a cogent reason or unless the agreement was not genuine. Based on the facts, MUK was not merely a customer facing entity but was in a position to negotiate with customers and handle scope and timing of deliverables. MUK had successfully endeavored to improve the revenue generation and inter alia, paid commission to its employees on sales. Furthermore, MUK had assumed market and credit risk. Consequently, MUK had acted as a distributor rather than as a marketing service provider. Accordingly, the return on sales to benchmark MUK was a reliable profit level indicator. 2 Development Consultants Pvt Ltd v DCIT [2008] 23 SOT 455 (Kol) 3 Furthermore, the return on sales methodology created incentive for MUK to generate more revenue which considered the respective advantages of both the parties necessitated by the significant share of revenue generated by the taxpayer from UK. The Tribunal noted that the distributors were not always required to have a fluctuating percentage of profit; to clarify, a fixed percentage of profit would still lead to fluctuating level of absolute profits based on sales generated. Relying on the UK HMRC Guidance, the Tribunal concluded that distributors would need to be compensated on a return on sales basis and not on a cost plus basis. The OECD TP guidelines emphasise functional similarities over product similarities and accordingly, the taxpayer s comparability analysis identifying comparable distributors of software products was appropriate. The taxpayer prima facie had no incentive to shift the tax burden to UK by resorting to the return on sales methodology when it actually enjoyed a tax holiday in India. Other transfer pricing issues The Tribunal has also decided in favor of the taxpayer on the following two transfer pricing issues: Secondment of employees by the taxpayer to associated enterprises The TPO held that the secondment was a recruitment service for which the taxpayer should earn a fee. The Tribunal appreciated the taxpayer s business rationale that the secondments were to enable the associated enterprises to perform onsite services and the taxpayer also benefited from the secondments in terms of generation of more offshore revenues, continuity of employment and skill development of employees on their return. The Tribunal recognised 3

4 an important principle that it was in the taxpayer s business interest to second the employees and a negative inference cannot be drawn merely because the associated enterprise benefited as long as benefits were derived by the taxpayer. The Tribunal further held that if the benefits derived by the taxpayer are much higher than the small amount of compensation, then no compensation should be asked for considering business acumen and business model of the taxpayer. Interest on late recoveries from associated enterprises The TPO held that interest should be charged on recoveries from associated enterprises beyond 60 days. In deleting this adjustment, the Tribunal concluded that since the associated enterprises did not recover interest from third parties for late payment, charging interest by the taxpayer was not expected. Furthermore, the Tribunal also considered that the Revenue authorities had not brought on record that the taxpayer was paying interest to its creditors or suppliers on delayed payments. The Tribunal recognised that after taking into account the commercial considerations and market practice, there was no justification to charge interest from associated enterprises. In another recent ruling issued by the Ahmedabad Tribunal in the case of AIA Engineering Ltd. 5, the Tribunal had taken cognisance of inter-company agreements, detailed functions and risks of that taxpayers' UAE subsidiary to conclude that the subsidiary was a distributor and not merely a marketing service provider. The above principles have wide applicability to distributors of goods and services. Taxpayers engaged in distribution and sales activities for their group entities should review their facts such as agreements, employee functions, remuneration and business strategies that would be scrutinised to determine their characterisation and arm s length rewards. The Tribunal s decision on the other transfer pricing issues will also be helpful for taxpayers across industries. Conclusion The Tribunal has rightly relied on international transfer pricing guidance to determine the appropriate characterisation and rewards of a distributor vis-a-vis a mere marketing service provider. In relying inter alia on the distribution agreement to reach its conclusion, the Tribunal has also reiterated an important principle earlier upheld by the Delhi Tribunal in the case of Sony India Pvt. Ltd 4. that the contractual terms of an agreement should be given due consideration as long as the terms are consistent with the economic substance of the transaction. 4 Sony India Pvt. Ltd. v. ACIT [ 2011] 141 TTJ 432 (Del) 5 AIA Engineering Ltd v. DRP [2011] 240 CTR 287 (GUJ.) 4

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