2 [2021]128
taxmann.com 260 (Pun-Trib)
1.5 Issue relating to interpretation of KPO / BPO / ITeS
Rule 10TA(e) contains the definition relating to ‘information technology-enabled services’ and rule 10TA(g) defines ‘knowledge process outsourcing services’. Rule 10TA does not contain a separate definition relating to ‘business process outsourcing services’ (BPO). Interpretational issues have arisen in respect of characterisation of transactions into various categories of services like ITeS, KPO and BPO which have a very thin line of distinction.
3 In this connection, the Special Bench of the ITAT Mumbai in the case of Maersk Global Centres (India) (P) Ltd. vs. ACIT, after analysing the relevant definitions in rule 10TA, held as under:
‘73. On a careful study of the material placed before us to highlight the distinction between BPO services and KPO services, we are of the view that even though there appears to be a difference between the BPO and KPO services, the line of difference is very thin. Although the BPO services are generally referred to as the low-end services while KPO services are referred to as high-end services, the range of services rendered by the ITeS sector is so wide that a classification of all these services either as low end or high end is not always possible. On the one hand, KPO segment is referred to as a growing area moving beyond simple voice services suggesting thereby that only the simple voice and data services are the low-end services of the BPO sector, while anything beyond that are KPO services. The definition of ITeS given in the safe harbour rules, on the other hand, includes inter alia data search integration and analysis services and clinical data-base management services, excluding clinical trials. These services which are beyond the simple voice and data services are not included in the definition of KPO services given separately in the safe harbour rules. Even within the KPO segment, the level of expertise and special knowledge required to undertake different services may be different.’
4 However, the Delhi High Court in the case of Rampgreen Solutions (P) Ltd. vs. CIT after considering the Special Bench decision of Maersk Global Centres (India) (P) Ltd. (Supra), held as follows:
‘34. We have reservations as to the Tribunal’s aforesaid view in Maersk Global Centres (India) (P) Ltd. (Supra). As indicated above, the expression “BPO” and “KPO” are, plainly, understood in the sense that whereas BPO does not necessarily involve advanced skills and knowledge, KPO, on the other hand, would involve employment of advanced skills and knowledge for providing services. Thus, the expression “KPO” in common parlance is used to indicate an ITeS provider providing a completely different nature of service than any other BPO service provider. A KPO service provider would also be functionally different from other BPO service providers, inasmuch as the responsibilities undertaken, the activities performed, the quality of resources employed would be materially different. In the circumstances, we are unable to agree that broadly ITeS sector can be used for selecting comparables without making a conscious selection as to the quality and nature of the content of services. Rule 10B(2)(a) of the Income Tax Rules, 1962 mandates that the comparability of controlled and uncontrolled transactions be judged with reference to service / product characteristics. This factor cannot be undermined by using a broad classification of ITeS which takes within its fold various types of services with completely different content and value. Thus, where the tested party is not a KPO service provider, an entity rendering KPO services cannot be considered as a comparable for the purposes of Transfer Pricing analysis. The perception that a BPO service provider may have the ability to move up the value chain by offering KPO services cannot be a ground for assessing the transactions relating to services rendered by the BPO service provider by benchmarking it with the transactions of KPO services providers. The object is to ascertain the ALP of the service rendered and not of a service (higher in value chain) that may possibly be rendered subsequently.
35. As pointed out by the Special Bench of the Tribunal in Maersk Global Centres (India) (P) Ltd. (Supra), there may be cases where an entity may be rendering a mix of services some of which may be functionally comparable to a KPO while other services may not. In such cases a classification of BPO and KPO may not be feasible. Clearly, no straitjacket formula can be applied. In cases where the categorisation of services rendered cannot be defined with certainty, it would be apposite to employ the broad functionality test and then exclude uncontrolled entities, which are found to be materially dissimilar in aspects and features that have a bearing on the profitability of those entities. However, where the controlled transactions are clearly in the nature of lower-end ITeS such as Call Centres, etc., for rendering data processing not involving domain knowledge, inclusion of any KPO service provider as a comparable would not be warranted and the transfer pricing study must take that into account at the threshold.’
Thus categorisation of services as BPO, KPO or ITeS could pose a problem in application of appropriate SH rates. In addition, there could be an ambiguity as to what is covered within the term ‘market research’ included in the definition of KPO services. In view of the distinct SH rates for each category, an inappropriate classification could result in larger tax implications.
1.6 Eligible assessee for the purpose of SH
Eligible assessee has been defined under rule 10TB to mean a person who has exercised a valid option for application of SH rules in accordance with rule 10TE, and
(i) is engaged in providing software development services or ITeS or KPO services, with insignificant risk, to a foreign principal;
(ii) has advanced any intra-group loan;
(iii) has provided a corporate guarantee;
(iv) is engaged in providing contract R&D services wholly or partly relating to software development, with insignificant risk, to a foreign principal;
(v) is engaged in providing contract R&D services wholly or partly relating to generic pharmaceutical drugs, with insignificant risk, to a foreign principal;
(vi) is engaged in the manufacture and export of core or non-core auto components and where 90% or more of total turnover during the relevant previous year is in the nature of original equipment manufacturer sales; or
(vii) is in receipt of low value-adding intra-group services from one or more members of its group.
Foreign principal referred to above means a non-resident associated enterprise. Various factors have also been provided which the A.O. or the TPO shall have regard to in order to identify an eligible assessee with insignificant risk [referred to in points (i), (iv) and (v) above] which are as follows:
a) The foreign principal performs most of the economically significant functions involved along with those involved in research or the product development cycle, as the case may be, including the critical functions such as conceptualisation and design of the product and providing the strategic direction and framework, either through its own employees or through its other associated enterprises, while the eligible assessee carries out the work assigned to it by the foreign principal;
b) The capital and funds and other economically significant assets including the intangibles required are provided by the foreign principal or its other associated enterprises, while the eligible assessee is provided remuneration for the work carried out;
c) The eligible assessee works under the direct supervision of the foreign principal or its associated enterprise which not only has the capability to control or supervise but also actually controls or supervises the activities carried out or the research or product development, as the case may be, through its strategic decisions to perform core functions, as well as by monitoring activities on a regular basis;
d) The eligible assessee does not assume or has no economically significant realised risks, and if a contract shows that the foreign principal is obligated to control the risk but the conduct shows that the eligible assessee is doing so, the contractual terms shall not be the final determinant;
e) The eligible assessee has no ownership right, legal or economic, on any intangible generated or on the outcome of any intangible generated or arising during the course of rendering of services or on the outcome of the research, as the case may be, which vests with the foreign principal as evident from the contract and the conduct of the parties.
2. PROCEDURE TO BE FOLLOWED TO APPLY SH RULES
In order to apply SH rules, the procedure as provided in rule 10TE needs to be followed, a summary of which is given below:
a) Application in Form 3CEFA to be furnished to the A.O. on or before the due date for furnishing of return of Income.
b) The assessee should make sure that the return of income for the relevant A.Y. or the first of the A.Ys. is furnished before making an application in Form 3CEFA.
c) The assessee needs to clarify whether he is applying for one A.Y. or more than one A.Y. Such option exercised will continue to remain in force for a period of five years or the period specified in the form, whichever is less. It is to be noted that in respect of option for SH exercised under rule 10TD(2A), i.e., w.e.f. 1st April, 2017, the period of five years is reduced to three years.
d) The assessee needs to furnish a statement to the A.O. with respect to the A.Y. after the initial A.Y. providing details of eligible transactions, their quantum and the profit margins or the rate of interest or commission shown. Such statement needs to be furnished before furnishing the return of income of that particular year.
e) The SH option shall not remain in force for the A.Y. after the initial A.Y. if
i. The eligible assessee opts out of SH by furnishing a declaration to the A.O.; or
ii. The same has been held to be invalid by the respective authority, i.e., TPO or the Commissioner, as the case may be.
f) Upon receipt of the Form 3CEFA, the A.O. shall verify whether the assessee is an eligible assessee and the transaction is an eligible international transaction.
g) In case the A.O. doubts the eligibility, he shall make a reference to the TPO for determination of the eligibility.
h) The TPO may require the assessee to furnish necessary information or documents by notice in writing within a specified time.
i) If the TPO finds that the option exercised is invalid, he shall serve an order regarding the same to the assessee and the A.O. However, an opportunity of being heard is to be given to the assessee before passing the order declaring the option invalid.
j) If the assessee objects to the same, he shall file an objection within 15 days of receipt of the order with the Commissioner to whom the TPO is subordinate.
k) On receipt of the objection, the Commissioner shall pass appropriate orders after providing an opportunity of being heard to the assessee.
l) Where the option is valid, the A.O. shall verify that the Transfer Price in respect of the eligible international transactions is in accordance with the circumstances specified in rules 10TD(2) or (2A), and if the same is not in accordance with the said circumstances, the A.O. shall adopt the operating profit margin or rate of interest or commission specified in said sub-rules, as applicable.
m) In the A.Y. after the initial A.Y., if the A.O. has reasons to doubt the eligibility of an assessee or the international transaction for any A.Y. due to change in facts and circumstances, he shall make a reference to the TPO for determining the eligibility.
n) The TPO on receipt of a reference shall determine the eligibility and after providing an opportunity of being heard to the assessee, pass an order and serve the copy of the same on the assessee and the A.O.
o) For the purposes of rule 10TE:
i. No reference to the TPO by the A.O. shall be made after two months from the end of the month in which Form 3CEFA is received by him;
ii. No order shall be passed by TPO after two months from the end of the month in which reference from the A.O. is received by him;
iii. Order shall be passed within a period of two months from the end of the month in which objection filed by the assessee is received by the Commissioner.
p) If no reference is made or order has been passed within the time limit specified above, the option for SH exercised by the assessee shall be treated as valid.
The SH rules provide for a time-bound procedure for determination of the eligibility of the assessee and the international transactions. In case the action is not taken by any of the Income Tax authorities within the prescribed time lines as provided in the rules, the option exercised by the assessee shall be treated as valid.
In a case where the Commissioner passes an order against an assessee by holding that the option of SH is invalid (after providing a reasonable opportunity of being heard), in absence of clarity in rule 10TE, it appears that the only recourse available with the assessee is to either determine the ALP as per the normal TP assessment route or to file a writ petition in the High Court.
3. OBSERVATIONS REGARDING REVISED SH
The erstwhile TP SH thresholds, especially for IT and ITeS (20% / 22%), Contract R&D (30%) were set so high that it was not commercially viable for most companies to show any interest in the SH and therefore there were hardly any taxpayers opting for it, leaving the SH as having largely failed to achieve its purpose.
In contrast, the APA Scheme introduced in 2012 has been a roaring success even though it is a lot more intensive and a time-consuming negotiation process than opting for the SH, which works on a self-declaration basis. The APA route is preferred as it calls for lesser annual compliance requirements and determination of the agreed TP method which is a closer approximation of the ALP and the option of converting to a bilateral APA route which would avoid any economic double taxation for the multinational group.
3.1 No comparability adjustment and allowance
Rule 10TD(4) provides that no comparability adjustment and allowance under the 2nd proviso to section 92C(2) [reference to the 3rd proviso to section 92C(2) seems to have remained inadvertently] shall be made on the transfer price declared by the eligible assessee and accepted under rules 10TD(1) and (2), or (2A), as the case may be.
For international transactions undertaken for the period up to 31st March, 2014, the 2nd proviso to section 92C(2) provided that if the variation between ALP determined as per the MAM and the price at which the international transaction has actually been undertaken does not exceed notified percentage (not exceeding 3%), the price at which the international transaction is actually undertaken shall be deemed to be the ALP.
For international transactions undertaken from 1st April, 2014, the 3rd proviso to section 92C(2) was inserted to employ a ‘range’ concept for determination of ALP where more than one price is determined by the MAM. It provides that if more than one price is determined by the MAM, the ALP in relation to an international transaction shall be computed in the prescribed manner, i.e., rule 10CA(7). The proviso to rule 10CA(7) provides that the variation between ALP determined under the rule and the actual price does not exceed the notified percentage, then the actual price shall be deemed to be the ALP.
For the A.Y. 2020-21, Notification No. 83/2020 dated 19th October, 2020 provides the manner and limits of price variation (not exceeding 1% of the actual price in respect of wholesale trading and 3% of the actual price in all other cases).
Thus, the objective of rule 10TD(4) is that in cases where the option of the SH has been accepted, there would be no further allowance on account of comparability adjustment.
3.2 Maintenance, keeping and furnishing of information and documents
It is important to keep in mind that the provisions of rule 10TD(5) provide that section 92D relating to maintenance, keeping and furnishing of information and documents by certain persons, i.e., (i) One who has entered into an international transaction, as prescribed in rule 10D; and (ii) a constituent entity of an international group in respect of an international group as prescribed in rule 10DA, will be applicable irrespective of the fact that the assessee exercises his option for SH in respect of any such transaction.
3.3 Furnishing of report from an accountant by persons entering into international transactions
Rule 10TD(5) also provides that provisions of section 92E relating to a report from an accountant to be furnished by persons entering into international transactions will be applicable irrespective of the fact that the assessee exercises his option for SH in respect of any such transaction.
3.4 Non-applicability of SH rules in certain cases
Rule 10TF provides that SH rules contained in rules 10TA to 10TE shall not apply in respect of eligible international transactions entered into with an AE located in:
(a) any country or territory notified u/s 94A; or
(b) in a no-tax or low-tax country or territory.
Section 94A(1) containing enabling powers provides that the Central Government may, having regard to the lack of effective exchange of information with any country or territory outside India, specify by Notification in the official Gazette such country or territory as a notified jurisdictional area in relation to transactions entered into by any assessee.
In exercise of its powers, earlier the Central Government had, vide Notification No. 86/2013 dated 1st November, 2013 notified Cyprus as a ‘notified jurisdictional area’. However, subsequently the said Notification was rescinded vide Notification No. 114/2016 dated 14th November, 2016 and Notification No. 119/2016 dated 16th December, 2016 with effect from the date of issue of the Notification. CBDT, vide Circular No. 15 of 2017 dated 21st April, 2017, clarified that Notification No. 86/2013 had been rescinded with effect from the date of issue of the said Notification, thereby removing Cyprus as a notified jurisdictional area with retrospective effect from 1st November, 2013. Thus, no such Notification is in operation now.
Rule 10TA(i) defines ‘no-tax or low-tax country or territory’ to mean a country or territory in which the maximum rate of income-tax is less than 15%.
3.5 Applicability of the Mutual Agreement Procedure
OECD TP Guidelines in para 4.117 have recommended modification of the SH outcome in individual cases under mutual agreement procedures (MAPs) to mitigate the risk of double taxation where the SH are adopted unilaterally.
However, Indian SH rules have taken an opposite view as compared to OECD TP Guidelines and have provided that MAPs shall not apply.
Rule 10TG provides that where transfer price in relation to an eligible international transaction declared by an eligible assessee is accepted by the Income-Tax Authorities u/s 92CB, the assessee shall not be entitled to invoke MAP under a Double Taxation Avoidance Agreement.
3.6 Impact of TP litigations in the preceding years on the choice for SH
In the Indian scenario, the existing SH as an alternate dispute resolution mechanism has not proved itself as an attractive option. SH, as compared to other available options, has showcased bleak growth. This is evident as the Indian taxpayers have maintained a safe distance from SH over the years.
There are a number of dispute resolution mechanisms available for a taxpayer in India which, although time–consuming, generally yield the desired outcome for the taxpayer. Further, the price / margin to be offered under the Indian SH is perceived to be on the higher side compared to the benchmarks and outcome obtained via other mechanisms.
In some cases, where SH rates were relied upon by the TPO without performing any benchmarking, the same have been rejected by the ITAT and the lower margin of the taxpayer is accepted. This is another reason that makes the SH route less lucrative and the reason for the taxpayer’s reluctance to opt for the SH, as the margins lower than those prescribed by the SH in certain segments are well accepted.
However, in many cases where prolonged TP litigation has been going on for many years and the differential tax impact is not significant, the assessees have opted for the SH regime in order to avoid long litigation and have certainty.
4. IMPLICATIONS OF SECONDARY ADJUSTMENTS
As per section 92CE, secondary adjustment means an adjustment in the books of accounts of the assessee and its AE to reflect that the actual allocation of profits between the assessee and its AE are consistent with the transfer price determined as a result of primary adjustment, thereby removing the imbalance between the cash account and the actual profit of the assessee. Such secondary adjustment is now mandated under the following scenarios where primary adjustment to transfer price
(i) has been made suo motu by the assessee in his return of income;
(ii) made by the A.O. has been accepted by the assessee;
(iii) is determined by an APA entered into by the assessee u/s 92CC on or after 1st April, 2017;
(iv) is made as per the SH rules framed u/s 92CB; or
(v) is arising as a result of resolution of an assessment by way of the MAP under an agreement entered into u/s 90 or u/s 90A for avoidance of double taxation.
Primary adjustment has been defined in section 92CE(3)(iv) to mean the determination of transfer price in accordance with the arm’s length principle resulting in an increase in the total income or reduction in the loss of an assessee.
4.1 Significant hardships and issues that can arise due to secondary adjustment
The stated purpose of secondary adjustment is to remove the imbalance between the cash account and the actual profit of the taxpayer and to reflect that the actual allocation of profit is consistent with the ALP determined as a result of the primary adjustment. The issues that can arise due to the same are as follows:
a. Enforcing the recording of such adjustment in the books of accounts of the AE would be difficult for the Indian taxpayer, especially in cases where the primary adjustment is on account of the SH option, or suo motu offering to tax. The Government had clarified that SH margins are not necessarily ALP but only an option to avoid litigation. In such cases, to mandate the AE to record the adjustment would be unfair.
b. The taxpayer may be prompted not to accept the primary adjustment in the first place but instead litigate the same. The provisions provide that secondary adjustment should be made if primary adjustment made by the A.O. is accepted by the taxpayer. This would discourage the taxpayer from making suo motu adjustments or opting for SH provisions. When the Government is looking at reducing litigation, these new proposals are not going to help achieve that objective.
4.2 Impact of secondary adjustment on adoption of SH
As provided in the 1st proviso to section 92CE, secondary adjustment will not be required in cases where the primary adjustment made in any previous year does not exceed Rs. 1 crore. In view of the same, where the scale of operations of an assessee is small and likely primary adjustment as per the SH rules does not exceed Rs. 1 crore, the secondary adjustment will not be applicable. In such cases, there will not be any impact on adoption of SH rules even if there is a primary adjustment.
Example
In the case of two assessees who are engaged in the manufacture and export of core auto components (where the SH rules provide that the operating profit margin declared in relation to operating expenses should not be less than 12%), the impact of secondary adjustment on adoption of SH will be as follows:
Amount in crores
|
Sr. No.
|
Particulars
|
Assessee A
|
Assessee B
|
|
1.
|
Operating Revenue (in crores)
|
Rs. 80
|
Rs. 20
|
|
2.
|
Operating Expense (in crores)
|
Rs. 75
|
Rs. 18.5
|
|
3.
|
Operating Profit (in crores)
|
Rs. 5
|
Rs. 1.5
|
|
4.
|
Operating Profit margin (3 ÷ 2)
|
6.67%
|
8.12%
|
|
5.
|
SH margin required
|
12%
|
12%
|
|
6.
|
Operating profit as per SH rules (5 x 2) (in crores)
|
Rs. 9
|
Rs. 2.22
|
|
7.
|
Primary adjustment to be made (6 – 3) (in crores)
|
Rs. 4
|
Rs. 0.72
|
|
8.
|
Whether secondary adjustment required
|
Yes
|
No
|
As we can observe from the above example, in case of assessee A the primary adjustment to be made is Rs. 4 crores. Accordingly, secondary adjustment will be required and this will have an impact on the decision of assessee A to opt for SH. On the other hand, in case of assessee B the primary adjustment to be made does not exceed Rs. 1 crore. Accordingly, secondary adjustment will not be applicable and it will not have any impact on the adoption of SH.
Further, section 92CE(2A) provides that where the excess money or part thereof has not been repatriated within the prescribed time [on or before 90 days from the due date of filing of return u/s 139(1)], the assessee may at his option pay additional income tax @ 18% on such excess money or part thereof as the case may be.
Where the additional income tax as specified above is paid by the assessee, section 92CE(2D) provides that such assessee shall not be required to make secondary adjustment under sub-section (1) and compute interest under sub-section (2) from the date of payment of such tax.
5. PRACTICAL DIFFICULTIES AMIDST COVID-19
CBDT vide Notification dated 24th September, 2021 has notified the SH margins for F.Y. 2020-21 and they are the same margins which were applicable for F.Ys. 2016-17 to 2019-20.
Enterprises which have undertaken international transactions during F.Y. 2019-20 and F.Y. 2020-21 may have to perform a pilot analysis for verifying whether their margins are in compliance with the margins prescribed by the SH rules. If not, they can always opt out of SH rules for the relevant A.Y. by making a declaration to that effect to the A.O. as envisaged under rule 10TE.
SH rules were introduced by the CBDT to establish a simpler mechanism to administrate companies undertaking international transactions and also to reduce the amount of litigation. Prescribing the same margins for the coming years would work against the purpose for which they were introduced.
The Covid-19 pandemic has given rise to a number of problems, posing great challenges at least from a TP perspective. Due to the changing business risk environment and difficulty in determining the ALP, it was hoped that the SH margins would be reduced to provide more breathing space to businesses. However, the CBDT vide Notification No. 117/2021, dated 24th September, 2021, extended the validity of the provisions of the SH rules to A.Y. 2021-22 without making any changes or adjustments on account of the pandemic.
6. SAFE HARBOUR RULES FOR SPECIFIED DOMESTIC TRANSACTIONS
Rules 10TH and 10THA to 10THD contain the provisions relating to SH rules for Specified Domestic Transactions.
Rule 10THA defines the eligible assessee to mean a person who has exercised a valid option for application of SH rules in accordance with the provisions of rule 10THC and (i) is a Government company engaged in the business of generation, supply, transmission or distribution of electricity; or (ii) is a co-operative society engaged in the business of procuring and marketing milk and milk products.
In view of the limited application of SH rules for specified domestic transactions only to specified businesses relating to electricity and milk and milk products, the same is not elaborated in this article.
7. CONCLUDING REMARKS
Introduction of SH was a crucial step towards reduction of TP litigations, allowing the Department to focus its resources on significant issues and improving the ease of doing business ranking and investment climate in India from a tax perspective. It has also ensured the reduction of the compliance burden on the taxpayers, enabling them to focus more on their core activities.
In order to make SH rules more attractive to the assessees, the requirement to still maintain detailed TP documentation (TP Study), including benchmarking, may be dispensed with. Only a brief note about the business and ownership structure with brief FAR details should be enough. That will reduce cost of compliance and make this SH simpler to comply with. Where later on the eligibility for SH is questioned, there can be a requirement made to the taxpayer to compile and present more detailed information at that point in time.
In view of the Covid-19 pandemic where the business entities have been impacted adversely to a great extent, a reduction in the compliance burden along with reasonable SH margins would enable them to get back on their feet. However, given the recent CBDT Notification to extend the validity of the SH margins without any adjustment on account of the pandemic, it may be advisable for the taxpayers to evaluate the comparable margins of the industry and the impact of Covid-19 on the industry, before opting for the SH application.
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3 [2014] 43 taxmann.com 100 (Mum-Trib) (SB)
4 [2015] 60 taxmann.com 355 (Del)
