Autodesk India v. Deputy Commissioner of Income Tax: Establishing Turnover Filters in Transfer Pricing ALP Determination

Introduction

The case of Autodesk India (P.) Ltd. v. Deputy Commissioner of Income Tax, Circle 11 (1), Bangalore adjudicated by the Income Tax Appellate Tribunal (ITAT) on July 6, 2018, addresses pivotal issues in the realm of transfer pricing. Autodesk India, a subsidiary of Autodesk Inc., USA, engaged in software development and marketing support services, contested orders by the Commissioner of Income Tax (Appeals), aiming to determine the Arm's Length Price (ALP) for international transactions with its Associated Enterprises (AEs). The central disputes revolved around the selection of comparable companies for ALP determination, with specific emphasis on turnover filters and the exclusion of certain comparables based on turnover size and profit margins.

Summary of the Judgment

The ITAT, under the aegis of Judicial Member N.V. Vasudevan, consolidated appeals for assessment years 2005-06 and 2008-09. The primary contention was the AO's determination of ALP for Autodesk India’s international software development services. Autodesk submitted that the price charged was at arm's length, supported by a Transfer Pricing (TP) study using the Transaction Net Margin Method (TNMM) with an Operating Profit to Operating Cost (OP/OC) margin of 10%, compared to an industry average of 9.73%.

The AO, after referring to the Transfer Pricing Officer (TPO), adjusted the ALP based on comparable companies, applying various filters such as turnover size, related party transactions (RPT), and functional comparability. Autodesk appealed the exclusion of certain comparables, arguing that turnover size should not preclude comparability. The CIT(A) partially upheld Autodesk’s appeal, specifically regarding the turnover filter, aligning with precedents that support considering turnover in establishing comparables. However, aspects related to abnormal profit margins and functional dissimilarity led to mixed outcomes, with some exclusions being upheld and others reversed.

Ultimately, the Tribunal upheld the CIT(A)’s decision to exclude companies with turnovers significantly higher than Autodesk’s, reinforcing the relevance of turnover size in transfer pricing analyses. Additionally, the Tribunal addressed issues related to abnormal profit margins, functional comparability, and the thresholds for RPTs, providing clear guidance on these aspects for future transfer pricing assessments.

Analysis

Precedents Cited

The Tribunal extensively relied on previous decisions to guide its judgment:

Genisys Integrating Systems (India) Pvt. Ltd. v. Dy. CIT [2012]: Established the importance of applying both upper and lower turnover filters to ensure comparability.
Pentair Water India (P.) Ltd. [2013]: The Bombay High Court held turnover as a critical factor in determining comparables.
Chryscapital Investment Advisors India (P.) Ltd. v. Dy. CIT [2017]: Explored the exclusion of comparables based on unusually high profit margins, though deemed its application on turnover as obiter dictum.
Sundeep Kumar Bafna v. State of Maharashtra [2014]: Emphasized following the earliest binding precedent in cases of conflicting decisions.
Director of Settlements A.P. v. M.R. Apparao [2002]: Discussed the per incuriam doctrine, asserting that inconsistent later decisions should be regarded as non-binding.

These precedents collectively underscored the necessity for consistent and reasoned application of comparative criteria, particularly focusing on turnover size, to maintain uniformity in transfer pricing methods.

Legal Reasoning

The Tribunal's legal reasoning was bifurcated into assessing turnover filters and functional comparability:

Turnover Filters: Autodesk argued against excluding comparables solely based on high turnover, contending that size does not inherently affect profit margins. The Tribunal, aligning with the Bombay High Court's stance, recognized turnover within a defined range (Rs.1 crore to Rs.200 crores) as a vital criterion for comparability. This approach ensures that the selected comparables operate at a similar scale, mitigating distortions in ALP determination.
Abnormal Profit Margins: The exclusion of Exensys Software Solutions Ltd. was justified due to extraordinary events (amalgamation) affecting its profit margins. However, Thirdware Solutions Ltd. was improperly excluded as there were no such extraordinary circumstances, highlighting the need for evidence-based exclusions.
Functional Comparability: The Tribunal upheld the exclusion of companies like Bodhtree Consulting Ltd. and Tata Elxsi Ltd. for being functionally dissimilar, i.e., engaged in different segments such as product development rather than pure software development services.
Related Party Transactions (RPT): The Tribunal adjusted the acceptable RPT threshold from 25% to 15% of total revenues, reflecting the industry standards and ensuring that RPTs do not skew comparability.

This multifaceted reasoning ensures that ALP determination remains robust, fair, and reflective of true market conditions.

Impact

The judgment holds significant implications for future transfer pricing cases:

Turnover as a Comparability Criterion: Reinforcing the importance of turnover size within a specific range will guide taxpayers and tax authorities in selecting appropriate comparables, thereby enhancing the accuracy of ALP determinations.
Functional Comparability: Clear guidelines on functional comparability prevent arbitrary exclusions, ensuring that only genuinely dissimilar companies are omitted from comparables.
RPT Thresholds: Lowering the RPT exclusion threshold necessitates stricter scrutiny of related party transactions, promoting transparency and fairness in transfer pricing assessments.
Consistency in Judicial Decisions: Emphasizing adherence to primary precedents over conflicting later decisions fosters legal certainty and uniformity in transfer pricing jurisprudence.

Consequently, this judgment serves as a critical reference point for similar disputes, influencing how comparables are selected and analyzed in transfer pricing cases.

Complex Concepts Simplified

Arm's Length Price (ALP)

ALP refers to the price that would be charged between unrelated parties in similar transactions under comparable conditions. It ensures that transactions between associated enterprises are conducted fairly, preventing profit shifting for tax avoidance.

Transfer Pricing (TP)

TP involves setting the prices for transactions between associated enterprises, typically in different tax jurisdictions. The aim is to reflect realistic market conditions to ensure fair taxation.

Comparables (Comparables Pool)

These are third-party companies that perform similar functions under similar circumstances as the associated enterprises. They serve as benchmarks to determine the appropriate ALP.

Turnover Filter

A turnover filter sets the minimum and maximum revenue thresholds for selecting comparables. This ensures that only companies of a similar size are considered, enhancing the relevance of ALP calculations.

Related Party Transactions (RPT)

RPTs are transactions that occur between associated enterprises. High levels of RPTs can distort financial results, making comparables less reliable for ALP determination.

Functional Comparability

This assesses whether the business functions, assets employed, and risks assumed by the associated enterprises and comparables are similar, ensuring that the selected comparables are truly comparable.

Conclusion

The Autodesk India judgment strategically reinforces the necessity of applying turnover filters and functional comparability in transfer pricing analyses. By upholding the relevance of company size and operational similarity, the Tribunal ensures that ALP determinations are both fair and reflective of true market conditions. Additionally, the adjustment of RPT thresholds aligns with industry standards, promoting greater transparency. This case not only aids in resolving current disputes but also sets a robust framework for future transfer pricing assessments, fostering consistency and precision in tax jurisprudence.