by Samir Gandhi (Mumbai), K.R. Sekar (Bangalore), Shanto Ghosh (Mumbai) and S.P. Singh (Mumbai)
India's transfer pricing officers in Bangalore and Hyderabad have recently taken an aggressive position regarding the markup on services provided on a cost-plus basis, proposing markups ranging from 25 percent to 40 percent.
Outsourcing units in India
In recent years, India has emerged as the preferred location for many multinational companies (MNC) from Europe and the United States for housing outsourced services. These services—also referred to as Business Process Outsourced (BPO) or Information Technology Enabled Services (ITES)—include, but are not limited to, providing call-center support services for a company's customers, providing administrative support services for the various group entities within an MNC organization and providing contract software development services. Most of these service centers are captive service providers to the MNC group.
Given the functional and risk profile of service centers in India, these entities are often compensated on a cost-plus basis; that is, all their direct and indirect costs of providing the services are reimbursed by the parent company with a markup. Depending on the specific facts and circumstances of the service provider, the cost plus markups that were put in place generally ranged from 7 percent to 12 percent.
Recent transfer-pricing audits
The third year of transfer pricing audits for outsourcing entities in India was completed on December 31, 2006. The audits pertained to international transactions that took place during the fiscal year ended March 31, 2004. One outcome of those audits for offshore service centers located in Bangalore and Hyderabad was an outright rejection of the existing cost-plus markups. The tax administration has proposed markups ranging from 25 percent to 40 percent, resulting in large income adjustments for these entities. More than 80 cases were selected for adjustment, and anecdotal evidence suggests that the total amount of income adjustments for these companies is in excess of $220 million.
Although most of these companies enjoy the benefit of tax holidays under the Income Tax Act, the incentives are not available to any transfer pricing adjustment made in the course of assessments. Accordingly, most of the companies that have incurred a transfer pricing adjustment will be liable to pay tax on the adjusted income. Because these adjustments are not automatically deductible in the other tax jurisdiction as an expense, they may result in economic double taxation.
Affected companies
The tax administration has segregated the administration of transfer pricing regulations in India into five separate and distinct directorates, each headed by a director of income tax (transfer pricing).These directorates are in Mumbai, Delhi, Kolkata, Chennai and Bangalore. All taxpayers with international transactions fall within the purview of one of these directorates. The aggressive markups proposed in the course of transfer pricing audits were restricted mainly to the Bangalore directorate (which has jurisdictional authority over all companies registered in Bangalore and Hyderabad). Moreover, several taxpayers within the Bangalore directorate that had identical facts and circumstances as in earlier years, and had previously had their transfer pricing policies audited and accepted, were handed down adjustments this year.
Basis of adjustment
There is limited publicly available information on the approach adopted by the tax administration for all cases in which adjustments were made. However, it is generally felt that the basis of the adjustments is not founded on sound economic principles, and does not meet the test of "reasonableness."
The following points regarding the approach adopted by the tax administration in proposing the aggressive cost plus markups are noteworthy:
- The tax administration has given little consideration to the functions performed, assets deployed and risks assumed by the Indian offshore entities and has chosen comparables that have significant intangibles, bear entrepreneurial risk and operate under vastly different business models.
- The method used to arrive at the purported comparables proposed by the tax administration lacks transparency; no search process or criteria have been disclosed in the final orders, and the final comparables indicate "cherry picking" high-margin comparables to justify the means of confirming a predetermined conclusion.
- The reasons cited to reject the comparables proposed by the various taxpayers lack sound economic reasoning and are applied in an arbitrary and inconsistent manner.
- The tax administration has not accepted proposed adjustments (for differences in risk profiles, differences in business structure, etc.) to improve the reliability of the analysis. Moreover, they have not provided sufficient reasons to reject the proposed adjustments either.
As a result of this approach, several companies had their markups revised to well over 30 percent. No attempt was made to differentiate between the types of services rendered and the economic circumstances under which the entities operate.
Dispute resolution mechanisms
Because India does not have a formal APA program or a safe harbor provision the taxpayer has access to two dispute resolution mechanisms for transfer pricing matters—Appeals and the Mutual Agreement Procedure.* The first level of appeal lies with Commissioner of Income Tax (Appeals). An appeal must be filed within 30 days from receipt of the assessment order (which includes the transfer pricing adjustment). The taxpayers that received a transfer pricing adjustment have opted to avail of this option. Since the total amount of the adjustments is very high, the appeals are likely to be escalated to the higher levels, which consist of the Income Tax Appellate Tribunal—an independent authority—and thereafter to the courts. This process will inevitably take a long time and the final outcome is uncertain.
The Mutual Agreement Procedure (MAP) is an alternative dispute resolution procedure that may be pursued. Under this scheme the foreign partner in the international transaction approaches its Competent Authority (CA), which in turn will approach the Indian CA for resolution of the dispute. Some transfer pricing cases are currently pending at the MAP stage.
Going forward
The tax officers in Bangalore and Hyderabad are likely to follow the approach adopted in the recent audits in the near future. The assessment of transactions entered into during the financial year ended March 31, 2005, will be finalized on or before December 31, 2007. This makes it imperative that a careful risk analysis of the exposure be undertaken, particularly in light of the recent FIN 48 requirements in the United States.
Finally, the approach adopted by the tax administration makes it critical that the existing prices/margins for service providers be substantiated using detailed documentation and a robust methodology. The documentation must clearly demonstrate that the captive service providers do not use any intangibles, bear no business risk, do not deploy unique assets, and provide the services in a competitive environment highlighting the alternatives available to the service recipient.
* The Authority for Advance Rulings (AAR) provides a third option. The AAR is an authority constituted by the Income Tax Act for resolving tax matters prior to an assessment. However, the AAR is not competent to take up issues that involve determination of fair market value of any property or transaction. Because of this, the AAR has avoided ruling in transfer pricing issues.