In a significant ruling, the Tax Tribunal has held that supplementary Transfer Pricing adjustments to account for ‘location savings’ accruing to a Multinational group by housing a part of its operations in India are not valid. The ruling was given by the Mumbai bench of the Tax Tribunal in the case of Watson Pharma.

Facts

The Taxpayer was an Indian affiliate of the Watson group and engaged in the business of contract Research and Development and Production activities in India for the group. The Revenue authorities bench-marked the operations of the Taxpayer with comparables engaged in similar activities in India and proposed a Transfer pricing adjustment on the basis that the margins earned by the Taxpayer were lower than the average margins of the comparable companies.

Adding insult to injury, the Revenue authorities sought to top-up the aforesaid Transfer pricing adjustments with additional adjustments to account for the “location savings” enjoyed by the group. The argument for location savings was inspired / supported by citing certain US tax precedents  and was quantified based on a research paper by Frost & Sullivan which estimated that MNCs enjoyed about 40% savings on account of location savings.

The Taxpayer objected to the adjustments made before the Dispute Resolution Panel (‘DRP’), the first level authority to decide Transfer-pricing related issues, but failed to get the issue resolved in its favour, as the DRP sided with the Revenue authorities. In the course of proceedings before the DRP, the Taxpayer was called upon to furnish details of the pricing of drugs supplied to its affiliates vis-a-vis the prices of such drugs in the Indian market and to show that savings were transmitted to end customers. The Taxpayer could only make partial compliance of this requirement, which was also viewed unfavorably by the DRP and influenced its decision.

Ruling by the ITAT

The ITAT ruled in favour of the Taxpayer and held that once the pricing arrangement entered into by the Taxpayer has been analysed and bench-marked with comparable companies under a recognized Transfer pricing methodology (i.e. Transaction Net Margin Method), no additional adjustments can be made to account for location savings. The Taxpayers argument that it was operating in a competitive field and therefore did not enjoy any special advantage with its peers was accepted. It was also pointed out that various jurisdictions compete with India for work from the parent/group companies.

The ITAT relied on the OECD report on Base Erosion Project and noted that the OECD report did not support Transfer Pricing Adjustments on account of location savings. The report being approved by G-20 countries, of which India is a member, was also a factor which was cited by the Tribunal to rule in favor of the Taxpayer.

 Our comment

In principle, where a Taxpayer has been subjected to Transfer Pricing analysis under a method mandated under law and exposed to consequences of such an analysis, that should be the culmination of the Transfer Pricing process. The Revenue arguing for additional adjustments based on purported application of certain general concepts and principles such as ‘location savings’, without any legal basis or support for such arguments, would quite naturally meet the fate that it did. That’s the easier part of the case.

The more difficult and tricky part is when a Taxpayer is called upon to furnish additional documentation to demonstrate that the savings were transmitted to the customer in support of its contention that it should not suffer additional adjustments for the purported location savings.  That there is a location saving when a Multinational sets up an operation in India is something which can hardly be disputed. But to expect a Taxpayer to show that such a saving did not accrue to it but was passed on to customers as a condition to avoid facing a TP adjustment, are expectation and analyses which are clearly beyond what the law requires.

It requires a certain clarity of thought to steer clear of such deflecting debates on the distribution of economic benefits of location savings and stick to the argument on points of law. Far more important, it requires a lot of finesse on the part of Taxpayer to put across the point that the Taxpayer deems it unwarranted to be dragged into a tangential analysis of his business / revenue models, beyond what is required under law, without at the same time coming across as being non-cooperative or worse, having something to hide.