Bad debts written off cannot be a factor to determine the Arms length price under any of the Transfer Pricing methods prescribed in the Income Tax Act, 1961.

This Article summarizes a recent ruling of the Mumbai Income Tax Appellate Tribunal (ITAT) [ITA no. 5420 and 5421/Mum/2006] in the case of CA Computer Associates Pvt. Ltd. (Taxpayer) on the issue of determining arm’s length price (ALP) of royalty paid by the Taxpayer to its associated enterprise for distribution of software products in India. The ITAT held that the disallowance made by the Transfer Pricing Officer (TPO) to the royalty, to the extent of the bad debts written off by the Taxpayer, was not in accordance with the transfer pricing (TP) provisions of the Indian Tax Law (ITL). According to the ITAT, as bad debts written off cannot be a factor to determine the ALP under any of the TP methods prescribed in the ITL, the TPO had exceeded his limitation.

Facts of the case

• The Taxpayer, a company incorporated in India, is engaged in the business of licensing and distributing mainframe, mid¬range and system infrastructure software products in India. The Taxpayer was appointed as the sole distributor in India for the products of a group company in the US (US Co).The Taxpayer had also set up a technical support centre in India to provide support services to end users of the software products on behalf of US Co.

• During the year, the Taxpayer made payments to US Co in the nature of royalty for distribution of US Co’s software products in India. In its return of income, the Taxpayer claimed deduction of such royalty payments. The Taxpayer had also incurred certain bad debts in the course of its business from sale of software products to unrelated customers, which were written off.

• The Tax Authority referred the matter to the TPO for determining the ALP as prescribed in the ITL. The Taxpayer had determined the ALP of the royalty payments, by applying the Comparable Uncontrolled Price (CUP) method. While the TPO accepted the CUP as the most appropriate method, a TP adjustment was made by way of disallowance to the royalty payments, to the extent of the bad debts written off. Hence, the ALP of the royalty for the sale made to the customers, whose receivable was written off, was determined as nil.

• The TPO’s order stated the following reasons for partially disallowing the royalty payments made by the Taxpayer:

• US Co, the licensor, was regularly intimated about the collection position with regard to invoices and, hence, in view of the uncollected invoices, US Co should not have claimed royalty on such amounts.

• Any independent entity, acting as sole distributor of US Co, would have sought waiver of royalty payable, considering the huge amount of non-receivables in the year. Further, existence of bad debts risk would be considered by independent parties while entering into distributor agreements in the initial years of business.

• If US Co had licensed the products directly to the clients, it would have suffered the bad debts.

• Royalty payments should be considered on the basis of actual collections and not just on the basis of invoicing.

• The invoices were raised and written off in the same year and hence, no royalty was payable annually.

• The Tax Authority followed the above order of the TPO. Against this, the Taxpayer appealed before the first appellate authority which upheld the Tax Authority’s order. Aggrieved by the first appellate authority’s order, the Taxpayer preferred an appeal before the ITAT.

Contentions of the Taxpayer

• Jurisdiction of the TPO is restricted to determine the ALP of any international transaction in view of the power vested in him under the provisions of the ITL.

• Specific methods have been prescribed in the ITL and the TPO is bound to determine the ALP of any international transaction within the framework of the methods prescribed by the statute.

• Writing off the bad debts cannot be the subject matter for determining the ALP under the powers of the TPO.

• Merely because the royalty payments were relating to the products sold by the Taxpayer to its clients, which payments could not be recovered, it cannot be a consideration before the TPO for deterring ALP of any international transaction.

Ruling of the ITAT

• The manner in which the ALP is to be determined by any of the methods is prescribed in the ITL and bad debts written off cannot be a factor to determine the ALP of any international transaction.

• The TPO has exceeded his limitation by following the method which is not authorized under the ITL.

• The ALP determined by the TPO and adopted by the Tax Authority is not as per the procedure prescribed and, hence, the same cannot be sustained.

Comments

For the purposes of the CUP method, an uncontrolled transaction is comparable to a controlled transaction, if none of the differences (if any) between the transactions being compared materially affects the price or some reasonably accurate adjustments can be made to eliminate the material effects of these differences. In considering whether controlled and uncontrolled transactions are comparable, regard should be had to the effect on price of broader business functions and allocation of risks arising from these functions.

The present ITAT ruling does not throw much light on the allocation of risks (specifically bad debts risk) between US Co and the Taxpayer or on whether the adjustment proposed by the TPO was to account for the difference in pricing likely to arise from the allocation of bad debt risk. Nevertheless, this ITAT ruling recognizes the principle that, in determining the ALP the TP methods should be applied strictly in accordance with the manner in which the same have been prescribed in the TP rules.