Transfer Pricing Alert

Facts of the case

Taxpayer, a captive software development and support service provider, is subsidiary of Novell Inc US. The taxpayer provided software development and support services to its US Associated Enterprise and adopted Transactional Net Margin Method.

Transfer Pricing officer (TPO) made adjustment of INR 8.50 crores by rejecting certain comparables of the taxpayer and selecting new comparables.

The taxpayer claimed depreciation adjustment before Dispute Resolution Panel (DRP) since the taxpayer was providing depreciation as per Straight Line Method (SLM) at the rates based on management’s estimate of useful life of assets which were higher than corresponding rates prescribed in Schedule XIV of the Companies Act 1956. DRP granted depreciation adjustment as claimed by the taxpayer.

The Tribunal dismissed the appeal filed by the Revenue and allowed depreciation adjustment claim of the taxpayer. Aggrieved, the Revenue appealed before the Karnataka High Court which was admitted by the Court:

Revenue’s Contentions before High Court

• Depreciation cannot be excluded from the cost of taxpayer as well as comparables. Rule 10B(1)(e)(iii) of the Income Tax Rules nowhere provides to exclude the depreciation as it will materially affect the adjustments and therefore, the same cannot be excluded.
• Tribunal has not considered whether the depreciation policy of the assessee is similar to comparables and has not given independent findings regarding reasons assigned by the TPO.

Taxpayer’s Contentions before High Court

• Since the taxpayer has the policy of charging higher rates of depreciation as compared to comparables selected by TPO, there is a definite impact on the net margins of the taxpayer as compared to comparable companies. Therefore, there is a need of making depreciation adjustment to eliminate the differences in accounting policy of the taxpayer and comparable companies in terms of Rule 10B(1)(e). 

• The Tribunal has rightly accepted this submission by relying on the decision of Hyderabad Tribunal in the case of Market Research Tools Pvt Ltd¹ in support of its contentions.

Karnataka High Court’s Ruling

The High Court held that there is a need for making the adjustment to eliminate the differences in the accounting policies of the taxpayer and the comparable companies in terms of Rule 10B(1) especially given that benchmarked international transaction is sales by captive service provider to its Associated Enterprise on which depreciation would have no bearing and thus can be excluded altogether.

While coming to this conclusion, the High Court made following observations:

• The High Court referred to the provisions of Rule 10B(I)(iii) of the IT Rules which specifies that before a comparison of net margins realised under sub clause (i) and (ii) is done, the net margin realised under sub-clause (ii) must be adjusted to take into account the differences which could materially affect the net profit margin in the open market.

• The High Court also referred to Rule 10B(3) which specifies that  an uncontrolled transaction shall be considered comparable if none of the differences between comparable companies and controlled transactions are likely to materially affect the profit arising from such transactions in the open market; or reasonably accurate adjustments can be made to eliminate the material effects of such differences.

• Since the taxpayer has the policy of charging higher rate of depreciation as compared to companies selected by the TPO, there is a definite impact on the net margins of the taxpayer as compared to the comparable companies.

• Thus, there is a need for making the adjustment to eliminate the differences in the accounting policies of the taxpayer and the comparable companies in terms of Rule 10B(1) especially given that benchmarked international transaction is sales by captive service provider to its Associated Enterprise on which depreciation would have no bearing and thus can be excluded altogether.

On Income Tax Issue relating to Section 14A, the High Court held that since no exempt income has accrued to the taxpayer, the provisions of section 14A of the IT Act do not apply to the fact situation of the case. The High Court relied on the decision of Madras High Court and Delhi High Court in the case of Chettinad Logistics (P) Ltd² and Cheminvest Ltd³ which have been affirmed by the Supreme Court subsequently. 

BDO comments

This High Court Ruling would provide comfort to the taxpayers to carry out the depreciation adjustments in Transfer Pricing documentation if there is a difference in the depreciation policy of the taxpayer as compared to the comparable companies and the circumstances require such adjustment.