Maersk Global Centres (India) Pvt. Ltd vs. ACIT (ITAT Mumbai Special Bench)

Transfer Pricing: Companies in ITES cannot be classified into low-end BPO services and high-end KPO services for comparability analysis but have to be classified based on the functions performed. Comparables with abnormal profit margins cannot be discarded per se but must be examined to determine whether the high margins are due to normal business conditions or not

The Special Bench had to consider two issues: Whether, for determining the ALP under TNMM, (i) a company performing (high-end) KPO functions is comparable with a company providing (low-end) back office support services, given that both are in the “ITES” sector? & (ii) companies earning abnormally high profit margin have to be discarded from the list of comparables? HELD by the Special Bench:

(i) As regards Q. 1, in view of the peculiarity of the ITES sector, the problem of performing a comparability analysis has to be solved by splitting the exercise into two steps in order to attain relatively equal degree of comparability, the first being to select the potential comparables at ITES sector level by applying the broad functionality test. By applying a broad functionality test, all entities providing IT enabled services can be taken as potential comparables;

(ii) In the second step, though further classification of IT enabled services may be required to be done, it cannot be on the basis of BPO (low end) and KPO (high end) services because the line of difference between them is very thin. There are a large number of services falling under ITES with significant overlap and it is difficult to classify these services either as low-end BPO services or high-end KPO services;

(iii) Instead, the purpose of attaining a relatively equal degree of comparability can be achieved by taking into consideration the functional profile of the tested party and comparing the same with the entities selected as potential comparables on broad functional analysis taken at ITES level. The principal functions performed by the tested party should be identified and the same can be compared with the principal functions performed by the entities already selected to find out the relatively equal degree of comparability. If it is possible by this exercise to determine that some uncontrolled transactions have a lesser degree of comparability than others, they should be eliminated. The examination of controlled transactions ordinarily should be based on the transaction actually undertaken by the AE and the actual transaction should not be disregarded or substituted by other transaction;

(iv) As suggested in the OECD Guidelines on Transfer Pricing, determining a reliable estimate of arm’s length outcome requires flexibility and the exercise of good judgment. It is to be kept in mind that the TNMM may afford a practical solution to otherwise insoluble transfer pricing problems if it is used sensibly and with appropriate adjustments to account for differences. When the comparable uncontrolled transactions being used are those of an independent enterprise, a high degree of similarity is required in a number of aspects of the AE and the independent enterprise involved in the transactions in order for the controlled transactions to be comparable. Given that often the only data available for the third parties are company-wide data, the functions performed by the third party in its total operations must be closely aligned to those functions performed by the tested party with respect to its controlled transactions in order to allow the former to be used to determine an arm’s length outcome for the latter. The overall objective should be to determine a level of segmentation that provides reliable comparables for the controlled transaction, based on the facts and circumstances of the particular case. The process followed to identify potential comparables is one of the most critical aspects of the comparability analysis and it should be transparent, systematic and verifiable. In particular, the choice of selection criteria has a significant influence on the outcome of the analysis and should reflect the most meaningful economic characteristics of the transactions compared. Complete elimination of subjective judgments from the selection of comparables would not be feasible but much can be done to increase objectivity and ensure transparency in the application of subjective judgments;

(v) On facts, the assessee is a captive contract service provider mainly rendering back office support services and incidental services involving some degree of special knowledge and expertise. It is not comparable to Mold-Tek & eClerx which are engaged in providing high-end services involving specialized knowledge and domain expertise in the field;

(vi) As regards Q. 2, potential comparables cannot be excluded merely on the ground that their profit is abnormally high. In such cases, the matter would require further investigation to ascertain 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. The FAR analysis in such case may be reviewed to ensure that the potential comparable earning high profit satisfies the comparability conditions. 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, 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.