Some Important Transfer Pricing Case Laws in International Taxation

Ruchi Gandhi

15 Feb, 2022

Today, all international transactions between associated enterprises are influenced by the transfer pricing regime in India and regulations under the Income Tax Act. In this post, we identified and summarised a few notable transfer pricing case laws in order to identify the key themes in international taxation that occurred in recent years.

Transfer Pricing Case Laws-

Engineering Analysis Centre of Excellence (Pvt.) Limited. vs CIT: Payment by resident Indian to non-resident computer software manufacturers did not constitute royalty

In this case, the petitioner was an Indian resident who sold shrink-wrapped computer software acquired directly from a non-resident firm. The petitioner did not deduct tax on payments made to the non-resident firm since the transactions involved a sale of products. However, the Department of Revenue, Ministry of Finance claimed that the transaction between the parties constituted a ‘copyright’ for the right to use the software, resulting in royalty payments and that tax should be deducted at the source under Section 195 of the Act.

According to the definition of royalties in Article 12 of the DTAAs, the Supreme Court of India decided that there is no duty under Section 195 to withhold tax at source on payments for software purchases. This is because of the fact that the distribution agreements or EULAs for such software do not establish any interest or right in such distributors or end-users, which would imply the use of or the right to utilize any copyright.

The provisions of section 9(1)(vi), as well as Explanations 2 and 4 thereof, which deal with royalties, could not be applied because they are not more favorable to assessees than the provisions included in DTAAs.

As a result, payments made by resident Indian end-users or distributors to any non-resident computer software manufacturers or vendors as a consideration for the resale or use of the computer software via EULAs/distribution agreements did not constitute royalty payments for the use of copyright in the computer software.

Bank of India vs ACIT: Refund can’t be granted of tax paid in foreign jurisdictions

In the case-law of the Bank of India, the Hon’ble Mumbai ITAT ruled that an Indian taxpayer will not be allowed to demand refunds from Indian tax authorities for taxes paid in foreign nations on income received in those jurisdictions if the same income is not taxed in India due to a loss. However, according to the rules of the DTAA, taxes paid are allowed as a deduction in the course of calculating Business Income, but only proportionately, and full foreign tax credit cannot be presumed permissible as a matter of course and normal practice.

According to the Mumbai Tribunal, the tax credit schemes, as evidenced by international tax legislation and model convention commentary, do not contemplate any situation in which the excess foreign tax credit can lead to a tax refund to a taxpayer from the exchequer of residence jurisdictions.

All ways of eliminating any double taxation, whether exemption, credit, or hybrid method, limit the liability to tax in the source jurisdiction. The remedy sought in this case goes well beyond that, resulting in a refund of taxes by India, and what is referred to be a refund is not even paid to the Indian exchequer.

When tax credits exceed tax liabilities, a carry forward or backup of the excess tax credit can be awarded at best if the domestic legislation allows it, or at best if the domestic law does not restrict it.

Concentrix Services Netherlands B.V versus ITO (TDS): Application of MFN Clause and Withholding Tax of 5% on dividend payment to a resident of Netherlands

In this case, the Honourable Delhi HC ruled that a withholding tax rate of 5% must be implemented when an Indian corporation pays a dividend to its shareholder in the Netherlands under the Most Favoured Nation (MFN) clause in the India-Netherlands Tax Treaty. This is one of the key transfer pricing case laws wherein the HC allows for a lower withholding tax.

Revenue maintained that the protocol annexed to the subject DTAA demonstrated that the advantage of the reduced rate of withholding tax would be accessible only if the nation with whom India entered into a DTAA was a participating member of the OECD at the time the subject DTAA was executed. None of the listed nations, namely Slovenia, Lithuania, and Columbia, were members of the OECD on the date the DTAAs with India was signed. As a result, Clause IV (2) of the protocol annexed to the subject DTAA would be inapplicable.

On writ, the Delhi High Court stated that a quick review of Clause IV (2) of the protocol annexed to the subject DTAA reveals that it embraces the principle of parity between the subject DTAA and subsequent DTAAs. Such parity is possible in terms of the withholding tax rate or the scope of the agreements in respect of income sources such as dividends, fees for technical services, interest, royalties, or payments for the use of equipment.

The principle of parity, on the other hand, applies only if the third country with which India enters into a DTAA is an OECD^[1] member. Furthermore, India should have reduced its withholding tax rate on subject remittances in its DTAA with the third State to a lower or more limited rate or scope than the rate or scope granted in the subject DTAA.

Once the aforementioned terms are met, the same rate of withholding tax or scope as stipulated in the DTAA executed between India and the third State must unavoidably apply to the subject DTAA as of the date the DTAA between India and the third State enters into force.

As a result, the favorable withholding tax rate of 5% in the India-Slovenia DTAA will apply from the date Slovenia became an OECD member, i.e., August 2010. The India-Slovenia DTAA, on the other hand, came into effect in February 2005.

Rack-space, US Inc. vs DCIT: Payment towards cloud hosting services does not constitute royalty

The taxpayer is a tax resident of the United States, and it earned income from cloud services such as hosting and auxiliary services given to Indian customers during the fiscal year (“A.Y.”) 2010-11. The taxpayer’s main argument was that the money earned was not taxable as royalties under Article 12 since the customers never had physical access to or exercised any sort of control over the equipment utilized by the taxpayer to supply cloud services. Furthermore, because the taxpayer’s services were not in the form of consultancy, managerial, or technical services, the sum received did not fall within the ambit of Article 12 of the Treaty.

The Mumbai ITAT determined that the arrangement between the assessee and its customer was for the provision of hosting and other ancillary services to the customer and not for the use or lease of any equipment.

The Data Centre and its Infrastructure were employed to supply the assessee with these services. Customers do not have physical ownership or custody of the servers, and the assessee is the sole owner of the authority to operate and administer this infrastructure or servers. The agreement stated that simpliciter hosting services would be provided but that the underlying equipment would not be rented or leased. The customer was unaware of any server placement in the data centre, webmail, websites, and so on.

Thus, the Assessing Officer and DRP had incorrectly classified the income from cloud hosting services as royalty defined under Explanation 2 to Section 9(1)(vi) and Article 12(3)(b) of the India-USA DTAA.

CIT vs Aerzen Machines (India) Pvt. Ltd: If there are differences in depreciation, PBDIT should be considered instead of PBIT

According to the Tribunal, the goal of transfer pricing regulations is to ensure that enterprises affiliated with one another and functioning on a global scale do not divert their money to another country. Thus, in order to calculate the Arm’s Length Price for transactions between two Associated Enterprises, the price or margin of one company (testing party) should be compared to firms that are comparable in terms of operations, capital employed, debt to equity ratio, the volume of turnover, risk, contractual conditions, assets employed, and so on. If for whatever reason, any of the items, such as capital employed or turnover, are not comparable to the tested party, then the necessary modifications must be made.

In this situation, the depreciation stated and reported by the assessee is extremely higher than the depreciation claimed by comparable enterprises. As a reason, it can be established that adjustments in the amount of depreciation are required. However, there are no rules or legal procedures in place that provide a framework for making such modifications to depreciation.

As a result, when calculating the Arm’s Length Price for foreign transactions conducted by the assessee with its Associated Enterprise, the AO should have used the PBDIT as the profit level indicator. This is one of the important transfer pricing case laws that throw light on the computation of arm’s length price.

Conclusion

The above-mentioned summaries of transfer pricing case laws provide an indication of the issues that tax authorities may be thinking about and encountering around the world. The outcomes of the cases suggest a greater emphasis on aligning tax arrangements with actual company practices.

Read our Article:Transfer Pricing Documentation and compliances