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COVID-19: Capacity adjustment in the case of Captive Service Providers – Judicial Precedents

By Venkatachalam, Rahul Mehta & Aayush Modi -

Even as we enter the second quarter of FY 2020-21 amidst Unlock 2.0, COVID-19 continues to have an impact on businesses. But whilst businesses start to reopen and the second quarter is expected to be better than the first, it is anticipated that it will take much longer for businesses to return to normal operating levels vis-à-vis earlier years.

In such situations where companies end up operating at much lower capacities, one of the most common questions being raised over various platforms is whether the captive service providers will be allowed to claim adjustments for the underutilized capacities due to COVID-19, or whether they will be expected to continue earning mark-up on total costs, including unabsorbed fixed costs since they are limited risk entities.

A captive service provider is set up to render services to its parent company or other Multinational Enterprise (‘MNE’) group companies. Generally, under this type of business model, the parent company sub-contracts the routine or low-end service functions to the captive service provider. The captive service provider is generally remunerated with a cost-plus arm’s length mark-up commensurate with functions, assets, and risk (‘FAR’) profile, and characterized as a limited risk entity.

It needs to be stated at the outset that low-risk entities or limited risk entities do not mean ‘no’ risk or ‘risk-free’ entities. There are economic circumstances whereby a limited risk entity would also need to bear the risks and related losses. The current situation resulting from the pandemic could be said to be one such scenario, where the parent company also has no control over the situation and it need not bear all of the losses through continuing to compensate the captive entities on total costs.

In a scenario where both parties believe and agree that the parent company need not compensate the captive service provider for unabsorbed fixed costs and extraordinary costs due to the pandemic, the question to address is what are the current regulations and judicial precedents which could provide guidance on how taxpayers can compute the arm’s length remuneration in such situations.

In this article, we have covered the allowability of economic adjustments for underutilized capacity as per the Indian TP regulations and the OECD, and certain judicial precedents in the case of captive service providers.

OECD TP Guidelines 2017 and Indian TP Regulations

The OECD TP Guidelines 2017[1] address the need to make reliable adjustments to eliminate material differences between controlled and uncontrolled transactions.

Similarly, the Indian TP regulations under rule 10B(3) of the Indian
Income-tax Rules, 1962 (‘the Rules’) stipulate that an adjustment can be made to eliminate differences between the transactions being compared, or between the enterprises entering into such transactions.

Rule 10B(3)

“(3) An uncontrolled transaction shall be comparable to an international transaction [or a specified domestic transaction] if—

(i) none of the differences, if any, between the transactions being compared, or between the

enterprises entering into such transactions are likely to materially affect the price or cost charged or paid in, or the profit arising from, such transactions in the open market; or

(ii) reasonably accurate adjustments can be made to eliminate the material effects of such differences.”

It can be seen from the above that, economic adjustment is permissible under the OECD and the Indian TP regulations to eliminate the material differences and to improve the comparability analysis. However, the allowability of such adjustment in a particular case depends on the specific facts and the FAR profile of the associated enterprises (‘AEs’).

From an India perspective, while making a capacity adjustment there are a number of factors to be considered, such as:

  • The rationale for making a capacity adjustment;
  • FAR profiles and terms as per the inter-company agreement between AEs;
  • Adjustment should be made on a tested party or comparables; and
  • Availability of reliable data.

The following are certain judicial precedents where the Hon’ble High Court (HC)/ Tribunals (ITAT)  have dealt with issues of capacity adjustment in the case of captive service providers:

Indian Judicial Precedents:

Sr.

No.

ParticularsSummary
1CIT  vs. Transwitch India P Ltd [TS-388-HC-2013(DEL)-TP]
Facts of the caseThe Assessee is a captive service provider and operates as a design center for its US-based parent company. The Assessee designs and develops software and also provides related services.

 

During FY 2005-06, the Assessee shifted its office due to the sealing drive of the Municipal Corporation of Delhi (MCD). As a result, the Assessee incurred the following costs:

·         Relocation expenses;

·         Additional payment of two months’ rent for a new office; and

·         Salaries for unproductive/idle hours (from 1 March 2006 to 25 March 2006).

 

Due to the sealing drive, the Assessee could not carry out normal operations in the period from 1 March 2006 to 25 March 2006. The costs mentioned above were unproductive costs and were not billed to the parent company.

 

As per the service agreement, the remuneration for software development services rendered by the Assessee was fixed at $35 per man-hour.

 

The unproductive hours during the aforementioned period were not billed to the parent company.

 

The capacity utilization of the Assessee during the quarter of January to March 2006 fell to 72%. By contrast, during the financial year ended 31 December 2005, normal capacity utilization lay between 87% and 94%. The fall to 72% resulted in reduced revenue during the financial year under consideration.

DisputeThe Transfer Pricing Officer (TPO) disallowed the adjustment of extraordinary expenses claimed by the Assessee due to the following reasons:

 

·      The Assessee did not provide the copy of the MCD notices whereby its office premises were ordered to shut down;

·      The Assessee had no communication with its parent company showing the Assessee’s inability to carry out work during March 2006;

·      On 8 March 2006, the Assessee’s custom license had already been renewed up to 31 December 2006 at the old address;

·      Shifting of business from one premise to another could have been performed over a weekend without causing disruption to the business of the Assessee;

·      The Assessee’s payment of additional rent for two months for its new premises defeated the Assessee’s argument that its work suffered due to the sealing drive;

·      The Assessee’s claim that it suffered a reduction in revenue due to the sealing drive was unsubstantiated; and

·      A comparability adjustment was not made in the TP report.

The decision of the HC  – Favorable to the AssesseeThe Hon’ble HC dismisses Revenue’s appeal against ITAT order allowing adjustment towards idle time and abnormal costs (towards relocation expenses and additional rent for new premises) incurred while relocating office premises.

 

The Hon’ble HC held that the aforementioned expenditure was incurred by the Assessee due to the unique problems it faced; these problems alone explained why the Assessee had to shift the location of its operations.

 

The abnormality and difficulty that resulted in extra expenditure were not created or caused by the AEs. They were not responsible or liable for the aforementioned payments/expenditure.

 

The AEs did not have a legal or contractual obligation to make extra or additional payments beyond the true and correct value of the transaction.

2Visteon Engineering Center (India) Private Limited vs. ACIT
[TS-462-ITAT-2018(PUN)-TP]
Facts of the caseThe Assessee is a captive unit engaged in the business of designing and developing products in the CAD/CAM of auto parts.

 

The Assessee had claimed an adjustment for capacity utilization in light of fact that its parent company (AE) and some of its subsidiaries in the US had filed bankruptcy petitions that had an adverse impact on the revenue of the Assessee.

 

Assessees revenue from the USA decreased by 47% and its revenue from Europe decreased by 54%. Due to a decrease in sales and the higher fixed cost of overheads, the Assessee experienced a sharp fall in business from INR 34.84 crores in the previous year to INR 21.04 crores in the year under consideration.

 

The Assessee could not reduce fixed overheads such as depreciation, property rental fees, and salaries in tandem with the reduction in business. Consequently, the profitability of the Assessee was also adversely affected.

 

The Assessee claimed an adjustment due to unutilized capacity while calculating operating margins, but the TPO rejected the claim.

DisputeThe TPO  rejected the capacity utilization adjustment made by the Assessee on the grounds that the adjustment was not supported by documentary evidence.

 

Furthermore, the Dispute Resolution Panel (DRP) rejected the Assessee’s plea for  granting the  capacity utilization adjustment for two reasons:

 

(i)      The global slowdown in the auto industry not only affected the Assessee but  other entities as well; and

(ii)     The capacity utilization adjustment was sought on the assumption that the parent companys filing of a bankruptcy petition did not materially affect the business of the Assessee.

The decision of the ITAT – Favorable to the AssesseeThe ITAT permitted the capacity utilization adjustment based on the reasoning that although the global meltdown may have affected the entire auto industry worldwide, the bankruptcy of the parent company was an event that was particular to the Assessee.

 

The ITAT directed the issue back to the TPO for de-novo consideration after examining the documentary evidence filed by the Assessee (i.e. a table giving the details of approved billable hours in Financial Year 2008-09 and Financial Year 2009-10) to contend that the business of the Assessee had substantially reduced.

3ION Trading India Private Ltd. Vs ITO [TS-643-ITAT-2015(DEL)-TP]
Facts of the caseThe Assessee is a captive entity and is engaged in the business of providing computer software development services to its AE only. The Assessee gets remunerated on a cost-plus basis.

 

The Assessee had claimed an adjustment on account of costs relating to rent and maintenance charges for underutilization of capacity due to expansion of business while calculating operating margins, but the TPO rejected the claim.

DisputeThe TPO disallowed the adjustment of costs relating to rent and maintenance charges for underutilization of capacity due to the following reasons:

·      Since the expansion was at the behest of the AE only, the compensation thereof should have been borne by the AE;

·      Expenditure on the enhancement of business is a routine operating expenditure undertaken with the intention of gaining more business;

·      The Assessee did not submit documentary evidence to support its claim. The  Assessee did not discharge the burden of proof;

·      The Assessee claimed adjustments in an ad hoc manner; and

·      Capacity adjustment in the service industry is not applicable as the business model is cost-plus and consequently, there is no question of idle capacity in terms of fixed costs/ assets.

The decision of the ITAT   Unfavorable to the AssesseeThe ITAT rejected the adjustment claimed by the Assessee and held that since the Assessee is a software service provider to its AE there can be no claim on account of underutilization of capacity as it was the AE who initiated such expansion.

 

Further, the ITAT rejected the adjustment claimed by the Assessee since it did not submit material to establish an objective basis on which its claim might be supported. ITAT held that the mere submission that there had been underutilization did not relieve the Assessee of the burden of proof connected with the underutilization. Moreover, the Assessee has not given any cogent basis to satisfy the reasons for underutilization.

Key takeaways:

Based on the judicial precedents, it can be said that a capacity adjustment would be allowed even in the case of captive service providers,  subject to  the following factors:

  • The unutilized capacity is due to reasons within or beyond the control of the AEs;
  • Quantification of unabsorbed fixed costs;
  • Availability of reliable data to claim adjustment;
  • The rationale for making an adjustment on account of unutilized capacity;
  • The terms of inter-company agreements between AEs;
  • Documentation maintained to support the claim for adjustment; and
  • The burden of proof lies with the Taxpayer.

 

Conclusion:

In the current economic situation, it is likely that the parent companies of many captive service providers will propose remunerating them on actual operational costs only, i.e. after excluding unabsorbed fixed costs such as rent, salaries, depreciation, and relocation costs.

The principles laid down in the above judicial precedents will be helpful for captive service providers to assess and then making claims for capacity adjustments and unabsorbed costs.

Authors :

Venkatachalam, Partner, Dhruva Advisors

Rahul Mehta, Principal, Dhruva Advisors

Aayush Modi, Sr. Associate, Dhruva Advisors