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GAP India vs Revenue

Published on Sat, Sep 22,2012 | 12:00, Updated at Sat, Sep 22 at 14:12Source : CNBC-TV18 |   Watch Video :

This week American apparel retailer gap won a 90 million dollar victory in a transfer pricing case in India. The moot question was the calculation of the arms length price paid by the global parent to its Indian sourcing subsidiary. Besides picking cost plus as the appropriate method, the Delhi ITAT also clarified several important principles that have been hotly contested between the tax department and taxpayers. Payaswini Upadhyay on how gap has filled the gaps!

243 billion dollars- that’s how much India’s exported between April 2011 and January this year. And while the Economic Survey does not explicitly ascertain how much of this export is via subsidiaries of foreign companies or third party purchases, it does impress upon India being an important procurement hub. So, the way, the tax department looks at the procurement functions performed by Indian subsidiaries becomes critical to ascertain their tax presence in India.

Vijay Iyer
Partner- Transfer Pricing, EY
"The sticky issue basically is that the tax office believes that when you're doing these procurement functions, you are performing a critical function in the supply chain and therefore you should get a percentage of the total value of goods procured from India and it could result in absurd profitability for the Indian company, but you should still get a percentage of the global turnover arising from India. This is totally contrary to the way we would look at a transfer pricing methodology for an activity like this because procurement is usually treated as a non-core activity and therefore when you're performing a non-core activity, you should try and target profitability based on the cost levels of the operations in India."

An argument that the Delhi ITAT was called to rule upon this week in GAP India's case- the moot question being that should the arm's length price be based on cost plus method or commission. GAP India- a sourcing arm of GAP US- said it should be cost plus; revenue said it should be commission based.

Alpana Saksena,
Senior Advisor, Transfer Pricing
KPMG
"If your model says that your characterization is substantively a service provider, then you would be expected to achieving profits which cover your costs and giving you a decent mark up. In contrast to this, revenue based models exist when you are performing a function in which you are driving the revenue and so you would expect a share out of it or percentage out of it. So if you're not seen as driving the revenue, then a revenue based model will not work in arm's length conditions."

An argument that found favor with the ITAT. The Tribunal ruled GAP India to be a low risk, procurement support service provider only. This on the grounds that the tax department failed to prove the following-  GAP India bore any business risk, that it undertook key functions, its human resources were an indispensable asset so as to amount to intangibles.

Alpana Saksena,
Senior Advisor, Transfer Pricing, KPMG
"Human resource, as an intangible, is coming up as a very important topic now. It is because if you have skilled resources, then you can expect compensations which are beyond the routine. So to that extent, a case by case analysis is being done by revenue to understand that whether intangibles are there who are being applied to the services so as to see whether the compensation that the company is receiving is commensurate with the intangibles that are being used for delivering services."

Vijay Iyer
Partner- Transfer Pricing, EY
"There are certain very important themes that have been laid down –one is in the context of location savings which clearly means that if you're using local comparables for benchmarking a particular activity, then all gains in relation to location savings have already been built in. So you don't need to do any further location savings adjustment if you already have a local set of comparables."

Besides the clarity on the principle of human intangibles and location savings, the most important point that the Tribunal has made is that any methodology should not result in absurd results. It noted that if the commission model suggested by the revenue is applied, it would lead to an exorbitant mark up of 800% of costs which it said was unrealistic, impractical and absurd. The Tribunal distinguished its earlier ruling in the case of Li and Fung to say that a percentage based model in Li & Fung did not result in such an exorbitant mark up on costs.

Alpana Saksena,
Senior Advisor, Transfer Pricing, KPMG
"Even if there were to be exorbitant margins, let's say in a case, then they would be fine as long as independent comparables who are in similar functionality and having a revenue based model are earning exorbitant arm's length mark-up. If that is supported, then probably, it would be acceptable that the present taxpayer should also earn it but since that was not the case, the Tribunal said it has to match the function being undertaken by the taxpayer. To that extent, the Tribunal has delved deep into the function asset risk. So its not that the Tribunal is against an exorbitant result, it's saying its fine as long as independent comparables are also attaining the same."

Vijay Iyer
Partner- Transfer Pricing, EY
"Very critical observation here is in the context of game theory – there is discussion in the order which says you cannot have service providers make 800% margin because if someone is making exorbitant margins, by principle of game theory, you would have that the customer would start negotiating prices downwards and both the customer and the service provider will have to come to a more reasonable outcome. So you cannot have a profitability which is totally out of sync with the industry. So that again goes beyond the industry; it goes to overall concept of game theory to say that unreasonable profitability cannot be ascribed to an activity because in commercial business, these profits will get adjusted and this is the first time this theory has been propounded in a Tribunal ruling."

And another first is the moot question of this order itself- cost plus vs commission based model for procurement service companies. May be, the Tribunal has taken a leaf from OECD's draft paper on Transfer pricing that was released in June this year. The draft paper has recognized that a functional analysis will determine the appropriate transfer pricing methodology. And though the ruling is fact specific, it certainly lays down principles that will give a leg up to the taxpayers position in future similar cases.

In Mumbai, Payaswini Upadhyay

 
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