Comparables and Transfer Pricing - case law review
Introduction To Transfer Pricing
Transfer pricing is a profit allocation method used to attribute a corporation’s net profit or loss before tax to tax jurisdictions. Sections 92 to 92F of the Income Tax Act, 1961 deal with a transfer pricing. Due to the increasing participation of multinational groups in India, there have been new complex issues emerging from transactions between two or more enterprises belonging to the same group. The price at which the goods and services are transferred between independent units of an organization is termed as “transfer price”. Such a price can be arbitrary and not in accordance of the market forces. This leads to the parent company or subsidiary incurring huge losses or producing insufficient taxable income. Hence these sections were framed, in order to provide guidelines for the computation of transfer price and documentation procedures. These are broadly based on the OECD guidelines (organization for economic co operation and development).
This legislation mainly deals with cross border transactions, “international transactions” are defined as transaction between two or more associated enterprises involving the sale, purchase or lease of tangible or intangible property; provision of services; cost sharing arrangements; lending/ borrowing of money; or any other transaction having a bearing on the profits, income, losses or assets of such enterprises.
The various methods of computing arm’s length price are:
(a) Comparable uncontrolled price method
(b) Resale price method
(c) Cost plus method
(d) Profit split method
(e) Transactional net margin method
(f) Any other method prescribed by the board
If price is determined by more than one method, the arms length will be determined as the arithmetic mean of the prices so determined.
Various Methods In Brief
· Comparable Uncontrolled Pricing
This is the most direct way of determining arms length price. Uncontrolled price is the price agreed between unrelated parties for the transfer of goods and services. It is of two types:
i) Internal CUP
The taxpayer enters into transactions with unrelated parties, and similar transaction is entered with related parties as well. Therefore in this case similar product is sold to a third party and the same is also transferred to an associated enterprise.
ii) External CUP
A transaction takes place between two independent enterprises under comparable conditions and comparable goods and services.
CUP is the most reliable method in case of internal CUP, but in this case also its has to be made sure that the following are thoroughly checked:
a) Type, quality and quantity of good sold and the good transferred to the associated enterprise.
b) Geographic market
c) Foreign currency risks
d) Intangible property
· Transactional net margin method (TNMM)
Under this method the net margin realized by the enterprise from an international transaction with regard to an appropriate base, along with this net profit margin from an uncontrolled transaction is identified. The differences between the two are adjusted with respect to the changes in the open market. The net profit so established is used to establish the Arm’s length price.
· Resale Price Method
This method reduces relevant gross profit mark-up from the sale price charged to free entity to reach the arm’s length price, primarily used when vendor adds little value to goods owned from associated enterprises.
· Profit split method
Three steps under this method that are applied in order to reach the ALP:
1. Net profit of the AE is computed
2. Compute relative contribution made by each of the AE to the earning of the combined Net Profit.
3. Split the combined net profit in proportion to their contributions.
This method is applied in cases where the international transactions are so inter related that they cannot be evaluated separately.
· Cost plus method
The cost incurred by the assessee in transfer is measured and sum of gross profit of other comparables is determined. The sum of gross spot arrived is used to take into account functional and other variation to determine ALP.
It is very difficult to find a similarly placed situation which can be compared to a transaction between two independent enterprises, even small variations in the two transactions may lead to a huge difference in the price estimated. Thus authorities should be cognizant of such differences even though the business activities are of a similar nature, suitable adjustments should be made in order to ensure necessary comparability.
In order to determine the arm’s length price of the tested company, an individual identical company has to be found as a comparable in case of non associated parties .The various information that is required in case of comparable companies are company activity, business description, ownership holding patterns, year of available financials and financials themselves. It has to be ensured that there are no differences in the situation of the comparables so as to affect the condition used in the method applied or in case of any differences, adjustments can be in such a manner that the differences get eliminated.
Analysis of case laws with respect to comparables:
· Intervet India Private Ltd. v. ACIT Mumbai-
adjustments have to be made under the CUP Method which include removal of material considerations such as price, cost or profit of the transaction against the third party, discounts, credit and foreign exchange risks, economic and market conditions.
· In Mentor Graphics (Noida) Ltd. v. Dy. CIT
The following set of comparables have to be made so as to eliminate differences:
a) Working capital
b) Adjustments for risk and growth
c) Adjustment for R and D expenses.
Different business activity
In DCIT v Global Services Private ltd.- The assessee company, which rendered its voice based customer care service to its associated enterprise, and chose the CUP method for assessment. However the TPO ( Transfer pricing officer) rejected and chose the Transaction net margin method as the most appropriate method. On appeal the CIT rejected this, and stated that CUP method was the most appropriate, as the comparables provided under the TNMM method do not belong to the same voice based BPO services as the assessee company.
· E Gain communication Pvt. Ltd. v ITO
The comparables taken in the instant case had extraordinary profit margins of 67.65% and 54.72% respectively , they had income from interest on deposit, dividend income , income from sale of licenses. Therefore since the line of business of the asseesee which was a software development company was materially different from the line of business of the comparables, therefore the comparables were excluded.
High or low profit margins
· Diageo India pvt Ltd v ACIt
Exceptionally high and low profit making comparables need not be excluded from the list of TNMM comparables, if functional comparability is present. US Transfer pricing regulations do allow comparables at the top and bottom of the range to be excluded, however this cannot be adopted in India as a matter of practice.
· E gain communication ltd.
The comparable employed for the application of Most Appropriate Method had huge extraordinary profit margins at 67.65% and 54.72%. The question arose whether the authorities had chosen appropriate comparables. The court held that as per Rule 10D only those differences that can materially be adjusted are to be considered. However in this the comparable has income from sources such as interest on deposit, dividend income, etc that increased the company’s profit to a large extent, the assessee being a software company could not include such income in their receipts. Therefore the court held that these companies cannot be taken as comparables.
· Sony India v. Dy CIT
The court held that the exclusion of a loss making company from the list of comparables was justified in the instant case. Though the sole criterion of profit margin or competition may not be enough for exclusion, but the cumulative effect of these factors as a whole may lead to exclusion. Since in the present case the comparable company had huge unutilized capacity, recorded negative growth, disputes with the employees, and needed financial restructuring, the court held that it could not be used as a comparable.
· Sapient Corporation Ltd. v Dy. CIT
The tribunal held that if the loss making companies are excluded from the list of comparables then the super normal profit making companies should also be removed from assessment.
· Adobe Systems Pvt v Addl CIT
A Software development service provider company had a profit margin of 14.96, the arithmetic mean of 42 comparables was found to reach the ALP .However the assesse said that 3 out of the 42 comparables should be excluded, as they depicted “super normal profit making”. On appeal this exclusion was allowed as on doing so the arithmetic mean was 17.15 which is within the 5% or -5% range permitted by S. 92(C) (2).
Multiple year data
· ADP Ltd. v Dy. CIT
As a matter of rule under 10B of sub rule (4) only data related to the financial year should be considered, but various case laws have laid down that data relating to the two years preceding the financial year can be considered if such transactions can influence the transactions being compared.
· Asstt. CIT v. Birla Soft ltd.:
The word “shall” in rule 10 (4) B can be clearly interpreted as stating the rule that for the purpose of comparability current year data has to be considered. And the previous two years data may be considered only in exceptional cases and cannot be employed as a rule.
· TNT India Ltd. v. Asstt CIT
It was held that the OECD guidelines are not of binding nature and that previous year data is only relevant if its data has been affected by it market conditions, business cycle etc.
Reference to the TPO
· Aztech Software and Technology services ltd. v Asstt. CIT -
The assessee company is involved in the business of development and export of software, since it had engaged in international transactions exceeding Rs. 5 Crore, it was scrutinized by the authorities. On enquiry it was found that the assessee had engaged in transactions with an associated enterprise. The AO officer made a reference of the matter to the TPO under Section 92CA for determining the ALP. It was contended that this act was erroneous since the prior approval of the CIT.IT was held that on a bare reading of section 92C and 92CA reveals that the AO can proceed with the determination of the ALP in cases of circumstances given in clauses a to d, and wherever he considers “necessary” or “expedient” he may refer the assessment to the TPO, there is no other requirement that needs to be fulfilled.
· Symantec Software Solutions v Asstt CIT:
Comparable was rejected on the ground that current years data was not available; again it was reiterated that earlier two years data should be considered only in cases where it will have an influence on the price. Also the selected comparable should be functionally comparable, any comparable majorly dealing in any other segment should be disqualified as a comparable.
The assessee contended that since its revenue from marketing support services was Rs 20 crore, all comparables having more than Rs 50 crore and less than Rs 5 crore turnover should be excluded. The Tribunal held that since the TPO had not made consequent adjustments , and any sort of abnormal difference in turnover that the operating profit of the comparable gets distorted then such a comparable should be excluded.
· DLH Express Pvt Ltd v. Addl Comm of Income Tax:
Issue : Whether the use of comparable with a turnover of less than 20% than that of the assessee correct.
Held that should be considered as it is a universal fact that there is a lot of difference between a small scale business and a large business operating in the same field. Small businesses are generally less profitable as economics of scale are not available. Segmental results of a company engaged in diverse activities should not be done as in such results certain type of expenditures, especially relating to interest and head office, are not allocated. Therefore when direct comparables are present, segmented results should not be used.
Related party transactions
· ADP Private Ltd. v. Dy. CIT
The assessee company was engaged in providing software development services, the relevant assessment year was 2004-05, where he received a sum of Rs 39 crore for its services at a cost plus mark up of 10%. The assessment when submitted with the TPO was rejected as the data for 2002-03 and 2003-04 was used by the assessee for computation and the comparables used by the assessee were rejected on the grounds that they had substantially related party transactions and some of the companies were functionally different.
The assessee submitted that since for transfer pricing sufficient adjustments with regards to the risk faced by independent enterprises, since in the present case the is in a kind of contractual transaction wherein it has been making profits year after year and does not have to incur any losses due to ultilization of capacity or insufficient business subsequent effect has been contemplated and proper adjustments have been made.
The court however held that risk adjustments have to be made only in certain cases depending on the facts and circumstances of the cases, a thumb rule cannot be applied in such cases. Also with regards to the facts of the instant case it was held that the previous year data was not relevant.
· Aztec Software case
The court held that though there are no guidelines as to what threshold should be used for inquiring into comparables and related party transactions but the court tried and interpreted the act itself to find a solution. The definition of associated enterprise as in Section 92 A (2) (b) which prescribes that in case a company owns 26% of the shares of a company it would be deemed to be an associated enterprise, also Section 40 A(2)(b) states that any person who carries more than 20% of the voting power of the company is defined as a person having a substantial interest in the company. Therefore interpreting the two provisions harmoniously the court said that 25% would a good estimated limit to check whether a certain comparable have related party transaction should be rejected.
However in Phillips Software Centre Ltd. v. Asstt. CIT held that the theory in Aztec was misplaced and that any comparable with even a single rupee of transaction with associated enterprises should be rejected, in all cases where the legislature intended to give a sufficient cut off they have done so as clearly proved from Section 10A (a) .Therefore since no such provision has been provided in case of related party transactions such cut offs cannot be assumed.
This was further upheld in Mentor Graphics (Noida)Ltd. v Dy. CIT
Analysis of the judicial trend
The judicial trend related to most aspects of comparables seem to be quite clear and the courts have been successful in laying down guidelines for companies so that they can chose the best available comparable for themselves. The researcher would now take one aspect at a time analyzing the arena of cases as discussed above and try to bring out a pattern in the list of essentials for a comparable to be used for applying any of the methods for transfer pricing.
Adjustments- The courts have broadly laid down that adjustments in case of the following have to be made before assessment- price, working capital, risk, foreign exchange, discounts, credits, market and economic conditions, R and D expenses, cost and profit of third party transactions.
However it must be remembered that adjustments may be made only of those which can materially be removed. The considerations that have been mentioned above are not exclusive, and at any time any addition can be made to this list , if it is proved that consequent adjustment is correct and any difference created by it have been materially removed. Further, in cases where there are a lot if adjustments to be made to the comparable it is better to avoid the use of such a comparable.
Different business activities according to the courts do not really constitute any essential unless such nature of activities affect the aspect which is being used under the most appropriate method such as in case of E Communications case, profit.
Though the position relating to “exceptionally huge profit or loss making” comparables is not very unclear as certain case do allow such companies to be included while other cases say that the US regulations cannot be read in India. However according to the researcher such comparables should not be excluded if other factors are sufficient to give it the stature of an appropriate comparable, and any differences caused can be adjusted by the authorities or the assessee.
Again in case of multiple year data the judiciary seems to be divided, while on side says that under Rule 10B it is mandatory that current year data be taken, the other side is of the opinion that since OECD guidelines allow multiple year data it should be allowed. I do agree with the present judicial trend in this matter as this multiple year data should not be employed as a rule but only in exceptional cases where the situation demands such data to be considered.
The judiciary in case of turnover have opined and clearly demarcated the difference between a large scale enterprise and a small scale one, and various adjustments that have to be made. Therefore it will be preferable that such comparables with varying turnovers are rejected and only where it can be sufficiently proved that such differences have been addressed through adjustments in an efficient manner.
Related party transactions is one area where cases widely differ from each other whereas ADP Pvt Ltd. case and Aztec Software are clearly in the favour of comparables being engaged in related party transactions another set of cases say that the analogy drawn by these cases is totally incorrect and that once a party gets into a related party transaction it has to be excluded from the list of comparables. I however differ from the latter case of Phillips software case, and believe that as seen in all of the above cases if a certain difference can be materially removed by such adjustments, such that that difference in that particular aspect is of no consequence there is no point rejecting it as a comparable altogether.
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