Transfer pricing Study Steps
Ø The basic theme while carrying out TP study
is to gain understanding on the following aspects
a)
Understanding of economically significant
characteristics of controlled transaction
b)
Understanding of respective role of parties in controlled
transaction
c)
Comparison of conditions of controlled
transaction and conditions in uncontrolled transaction taking place in
comparable circumstances
Ø Economically Significant characteristic of
controlled transaction and respective role of parties, which could materially
affect prices or profits in transaction, is determined by evaluating 5
comparability factors as under:-
1.
Characteristic of property or service
transferred
2.
Functions performed by parties taking into
assets employed and risk assumed. (FAR or Functional analysis)
3.
Contractual terms
4.
Economic circumstances
5.
Business Strategies
Ø The steps involved in transfer pricing study are as
under:-
1.
Understanding basic information on enterprises
& Controlled transaction
2.
Evaluation of
5 comparability factors
3.
Selecting testing party & Preliminary
decision on transfer Pricing Method applicable based on respective features,
strengths and weakness of each of the methods.
4.
Development of search criterion for
identification of comparable
5.
Identifying potential comparable transaction
6.
Comparability adjustment where appropriate
7.
Selection of most appropriate transfer pricing
method
8.
Determination of arm’s length price of
profits (or range of prices or profits)
9.
Documentation of comparability analysis
If upon
performing step 5 & 6, no suitable comparables can be found, then steps
from 3 onwards has to repeat again, adopting different probable most
appropriate method.
1. Gain understanding on basic information on enterprise and controlled
transaction on following aspects:-
a)
Collection of information about taxpayer to
understand its business operation and activities i.e, industry to which
taxpayers belong, the nature of its activities ( i.e manufacturer, wholesaler,
distributor etc.) , its market segment, market share etc.
b)
Identification of associated enterprises
involved in controlled transaction
c)
Nature of controlled transaction, Nature of
products/services transferred, value thereof, terms and conditions, type of
intangible used.
d)
Gain understanding of industry, competition,
economy, regulatory factors and other elements that may significantly affect
the taxpayer and its environment
2.
Comparability factors
Enterprise
and controlled transaction should be evaluated on following 5 factors:-
a) Characteristic of the property or services transferred.
b) FAR Analysis
c) Contractual Terms
d) Economic Circumstances
e) Business strategies.
The above-said
analysis should culminate in arriving at the following:-
a) Tested party- The tested party should normally be the least complex
party to the controlled transaction and should be party in respect of which the
most reliable and data for comparability is easily and readily available.
b) Preliminary decision on transfer Pricing Method applicable based on
respective features, strengths and weakness of each of the methods.
c) Development of search criterion for identification of comparable
a.
Characteristics of
Property or service transferred.
Product comparability holds prime importance, if Comparable
uncontrolled price method is to be followed. In general following features
needs to be captured to evaluate the Characteristics of Property or service:-
a) In case of tangible property,
the physical features, quality & reliability, brand.
b)
In case of services, nature and extent of services
c)
In case of intangible property, the form of the transaction (License or sale),
Type & form of property (Marketing Intangibles- Trademark, Trade name or
Production Intangibles – Patent, Know-how etc.), duration and degree of
protection, anticipated benefits from use of property.
In case of Resale
price Method, Cost Plus Method, the strict product comparability is not
required, but following features merit attention:-
a)
Category of Product or Service- For
example Tangible goods can be categorized as “home entertainment”, “household
appliances” or “machine tools”, etc.
b)
Product Life Cycle - For Example all sorts of TV, whether Normal
TV, LCD, LED falls under Home entertainment, but normal TV is only declining
phase, LCD is on stagnating phase and LED is on rising phase. Their margin
cannot be same.
Though TP methods will be
determined post FAR analysis, the reference to methods above given for
understanding purpose only.
In Recent judgment by
Mumbai Tribunal in Serdia Pharmaceutical, it was held that Brand is not
distinguishing factor to establish product comparability. The gist of the case
is as under;-
a) Assessee
is engaged in manufacturing and distribution of Drugs in Finished Dosage Forms
(FDF). Assessee was commanding huge
market share and also claiming to have purity level much higher than its peers
because of its brand.
b) It
was importing API from its AE, whose patents has expired, international
transaction.
c) Assessee
was paying higher price for API imported from AE, which was available at
cheaper price than procured from AE.
d) Assessee
adopted TNMM and carry out is TP study.
e) TPO
rejected TNMM and adopted CPU as most appropriate method for benchmarking API
imported from AE.
f) Court
upheld that TPO stand.
b) FAR – Analysis
FAR Analysis refers to Analysis of Functions Performed, Assets
Used, Risk Undertaken by
respective parties in controlled Transactions.
Ø Functions
The range of functions performed can be broadly categorized into
following:-
i)
Manufacturing of goods
ii) Distribution of goods
iii) Service Provider
i)
Manufacturing
Function
Assessee engaged in manufacturing business, can be broadly divided
into 2 categories based on functions
performed:-
a) Contract Manufacturer
b) Full-fledged Manufacturer
Contract Manufacturer
1. They do not develop their own product line but offer expertise in
performing certain manufacturing operations
2. They may or may not perform such functions as material purchasing
and production scheduling or own inventory.
3. They do not face direct marker risk as they guaranteed revenue
stream
4. The contract manufacturer intangibles are limited and typically
consist of know-how pertaining to manufacturing process.
5. Little risk
6. Quality Control usually dictated.
7. Usually manufacturing high volume, mature products
Full-fledged Manufacturer
1. They develop their own product lines and may have substantial
R&D Budget or may obtain the technology they require through license.
2. They perform all manufacturing functions, such as vendor
qualification, materials purchasing, production scheduling and quality control
procedures.
3. They are typically extensively involved in marketing to the ultimate
customers (or end-users) of the product.
4. They bear several types of risk, including inventory risk and market
risk.
5. Direct control over quality.
Categorization
of assessee business, i.e whether contractor or full-fledged manufacturer,
helps in identification of comparable
Manufacturing
Functions- Following functions needs to evaluated
for assessee engaged in manufacturing activities so as to arrive at proper
categorization of business:-
1)
R&D and Technology
a. What R&D is undertaken?
b. Is R&D carried out on the firm’s behalf by related companies
c. Are third parties engaged to carry out research and development
d. Where are the products designed
e. How important is the development of the patent in the industry.
f.
What patents are owned that create
unique products competitors cannot duplicate.
g. What unpatented technical know-how has been developed that might
differentiate its products from competitors, create important cost efficiencies
or provide an advantage in increasing market share.
2)
Product Strategy and Design.
Product strategy and design is the
process by which a firm decides which market segment to pursue, what product
characteristic are needed to meet the market demand, the types of products that
will be produced to satisfy the demands and selection of materials and
processes that will create these products.
3)
Manufacturing process
a. What is manufacturing process ? How are the firm’s goods
manufactured- the most important steps involved.
b. Who developed the original process
c. How fast does it change.
d. Have any improvements been made locally.
e. Has the firm utilized a third party to manufacture its products.
4)
Purchasing
The purchasing function involves
identifying and qualifying vendors, arranging delivery from vendors and
providing quality control.
Who performs the purchasing function,
plans purchasing schedules, negotiates purchasing arrangements and approves the
vendor of being acceptable quality.
5)
Inward Logistics
Inbound logistics includes
transportation, warehousing and other functions necessary to co-ordinate the
movement of materials to production site from unrelated and related party
processing or distribution facilities.
6)
Packaging and labeling
The packaging and labeling function
refers to the manner in which a product is packaged and labeled for shipment to
a buyer. Packaging and labeling requirements are often affected by a legal and
regulatory environment of the party shipping and the party receiving the
products
a) What packaging and labeling is done
b) Where it is done
c) Who makes the decision in relating to packaging and labeling
7)
Production scheduling
The production scheduling function is
undertaken by manufacturer to determine which products are to be manufactured,
when they are to be manufactured and what production volumes should be achieved
for the products.
a)
Who schedules production?
b)
Who/what influence the
production schedule
c)
Who determines the product mix?
d)
Who controls the inventory
levels
e)
What is the inventory holding
period.
8)
Outward logistics
Same as inward logistics.
ii)
Distribution Function
Assessee engaged in distribution business, can be broadly divided
into 3 categories based on functions
performed:-
a) Manufacturer’s Representative
b) Limited Distributor
c) Marketer/Distributor
Manufacturer’s
Representative
1. Does not take title to goods
2. It bears neither credit risk nor inventory risk
3. It does not have marketing responsibilities
4. He is typically remunerated by way of commission on the sales
revenue generated
Limited
Distributor
1. Takes title to goods
2. Limited credit and inventory risk but not bear foreign exchange risk
on purchase from its suppliers
3. Limited marketing responsibilities
Marketer/Distributor
1. Takes title to merchandise
2. Bear credit & inventory risk and may have foreign exchange risk
3. Total marketing responsibilities for its product lines
Marketing, Advertising and Distribution.
Marketing is broad definition encompassing
following activities: -advertising, market research, media planning, public
relations, product pricing, distribution, customer support, sales strategy, and
community involvement.
Marketing
1)
Marketing strategy and Development
Marketing strategy and development
functions are those activities that determine the positioning of a firm’s
product in a market and establish marketing techniques that bring products to
the customer’s attention.
a.
Which entities perform
marketing function.
b.
Are market survey performed.
c.
Which entities monitor market
demand.
d.
What are the risks related to
demand for the firm’s products.
e.
Who formulate the marketing
budget
f.
Do related companies undertake
marketing?
2)
Marketing & Advertisement
Marketing function includes overall development of brand
awareness in the market place and the creation and implementation of product
specific campaigns
a) What form of marketing does firm utilize?
b) What form of advertising is used?
c) Who pays for it
d) Are trade shows used, and if so, who organize them and who pays for
them
e) Are sample provided to distributor
Distribution
3)
Sales and Pricing
Product pricing has strategic and
tactical components. Strategic pricing involves a trade-off between products
margins and sales volume. Tactical aspects involve price adjustments to meet
local or temporary market conditions, establish prices for product improvements
or assist distributor in meeting competitive challenges
a.
How price determined?
b.
Which is more important in
determining the pricing structure: Product margin or volume?
c.
Is there published price list?
d.
On a tactical level, can prices
be changed to meet specific customer demand?
e.
What approvals are necessary?
f.
Who formulates the projection
and sets targets
g.
Who is responsible for
achievement of sales targets?
h.
Who negotiates sales contract
4)
Distribution Network
Distribution network enable the firm to locate
customers, determine their needs and provide services or products to meet those
needs. In addition, these networks enhance firm’s development of a
trademark/trade name
a) How is the products distributed
b) Who has developed the distribution network
c) Were customer list obtained
through acquisition
d) How responsive is the distribution to changes in the marketplace
e) Who manages the network
f) Has the network expanded or contracted in the recent years
Others
5)
Order Processing
The order processing function involves taking the
customer order from sales personnel, relaying the product order to inventory
control personnel, ensuring the order includes all requested items and relaying
the products to the shipping department and billing information to the
accounting office.
a) Where are sales orders received?
b) Who issues the invoice to the customer?
c) Who track the fulfillment of an order?
d) To whom does the customer speak to determine the status of an order
6)
Installation and after sale services
After sale
services is means by which a firm differentiated its products from
others. After sale services includes developing technical support and training
for distributors and dealers; providing distributors with advice and training
to improve operations and profitability ; and ensuring component availability
a) Does the firm undertake installation of its products
b) Does the firm provides after sale services
c) Who bears the cost of installation and after sale services
7)
Warranty Support
The Warranty support function is generally performed by
the entity from which the customer receives a level of services prescribed by
the legal obligation under the warranty.
a) Are the firm’s product under warranty
b) What are the terms of the warranty
c) Who establishes the terms
d) Who fulfills the obligation of warranty
e) Are unrelated party vendors involved
f) Who bears the cost
ASSET USED
The analysis should involve identification of the type of capital
asset used (e.g plant & equipment, intangible assets, financial assets
etc) and the nature of assets used, such
as the age, market value, location, property right protection available.
Usage of asset under FAR analysis is more relevant in manufacturing
concern, where value and age of assets do have effect on Price or
profitability.
Risk Analysis
1. Market Risk – It occurs due to increased competition in the market, adverse
demand conditions in the market or
inability to develop markets or position products to service targeted customers
a. What are market risks
b. How significant are market risk
c. Which entity bears the market risk
d. Do competitors bear the same risk.
e. How do competitors react?
The extent of market risk depends on the degree of
competition and economic structure in market.
The existence of limited competition within a particular
industry or product sector can arise from a number of factors. Barriers to
entry by new firms, such as government regulation or the need for an extremely
large initial investment (the development and commercialization of new drugs in
the ethical pharmaceutical market is a good example). Even if there is more
than one firm in the industry in question, a company can establish a
competitive advantage by developing a patent or proprietary know-how that
essentially bars or inhibits competition in a particular product or market. If
such barriers exist, they can have a material impact on the degree of market
risk faced by a particular firm.
Market risk also vary with sensitivity of the industry
to general economic conditions.
2. Product liability risk- It is borne by a firm when
its products fail to perform at accepted or advertised standards. Often product
liability risk develop when by failing to perform to standards, a product cause
its users bodily harm
a) What precautions are taken to protect the firm from product
liability risk
b) How significant is the risk
c) Is there insurance? If so, who pays premium.
3.
Customer credit risk
a) What credit terms are offered and received to related and unrelated
party
b) Who bears the risk of bad debts
c) Is this significant risk
d) What measures are taken to reduce/eliminate bad debts
4. Foreign exchange risk- It occurs when purchase of materials, resources, or services are
denominated in one currency, while sales of finished products are denominated
in another currency
a) Which entities are exposed to foreign exchange risk
b) Is this significant risk
c) Who bears the responsibility for the exposure?
d) What steps are taken to reduce or eliminate exposure?
5. Inventory Risk- It relates to the losses associated with carrying finished product
inventory. Losses include obsolescence, shrinkage or market collapse, such that
products are only salable at a price that produce a loss
a) Does inventory become obsolete
b) Who bears the cost of obsolete inventory
c) How is obsolete inventory disposed of?
d) Are cost recovered and reallocated.
6. Scheduling risk- This risk is assumed by a manufacturer in deciding when to make a
certain products
a) How time sensitive is the manufacturing/distribution process?
b) How sensitive is the product to make
c) Are these significant risk
d) Who bears scheduling risk, both inbound and outbound.
7. Product Technology Risk- The risk of obsolescence or
stranded assets in response to behavioral or technological change is a form of
product risk.
8. Operational Risk - It relates to the physical performance of the assets operated and
managed by the business, and the scope for them to be affected by events beyond
a business control.
9. Financial Risk - It relates to the relationship between the firm’s revenue and its
financing costs.
10. Manpower Risk - This risk is associated with the attrition of skilled/ trained
manpower which involves time and cost overruns to replace
11. Capacity Utilization Risk - This risk arises when the installed capacity for a manufacturer or
service provider is not optimally utilized and the companies have to bear fixed
costs associated with excess capacity.
c) Contractual Terms
The Contractual Terms generally covers the
following:-
i)
Form of Consideration charged or paid
ii)
Sales and Purchase Volume
iii)
Warranties provided
iv)
Right to revision and modification
v)
Delivery terms
vi)
Credit & Payment terms
1.
Explicit contractual terms of transaction may
provide evidence as to the form in which the responsibilities, risks and benefits
have been assigned among parties to transaction
2.
The extent to which contractual terms matter in
establishing comparability will depend upon
the nature of the controlled transaction and the pricing method
adopted. For instance,
if the controlled
transaction is a
license agreement and
the transfer pricing method the
comparable uncontrolled transaction method, information on the key contractual terms (duration, geographic area,
exclusivity, etc) can be assumed critical to assess the
reliability of the comparison. On the other hand, if the controlled transaction
is the provision of accounting services and the comparison made with the price of
similar services offered by
accounting firms, details on contractual terms such as payment terms are
unlikely to be of great significance.
d)
Economic Circumstance of Transaction
It involves analysis of controlled transaction, Associated enterprises
and comparable transaction on following aspects;-
1.
Geographic location of the market
2.
Market size
3.
Level of the market (Wholesale or retail)
4.
Competition in the market and relative position of
buyers and sellers
5.
Availability of substitutes
6.
Government regulation of the market
7.
Level of supply and demand
8.
Consumer purchasing power
9.
Location specific cost of production including the cost of land, labour, capital and
transportation cost
10.
Economic condition of overall industry, key value
driver in the industry
11. The existence of
cycle (economic, business, product cycle). Where a
cycle is involved taxpayers should make an effort to
explain why they believe there is a cycle, what type of cycle it is (business
cycle, product cycle…),
what the duration
of the cycle
is, where the
controlled enterprise is situated in that cycle and in what way and to
what extent the cycle is expected to impact on the data to be used in different
types of transfer pricing methods (i.e. price, margin, function, risk etc.)
In Skoda Auto India (P) Ltd 30
SOT 319 (Pune Tribunal), assessee was succeeded in remanding the case back
to AO, mainly on the strength of ECONIMIC CIRCUMSTANCES of assesse was
different from comparables.
1.
The assessee, an Indian company was manufacturing
and selling cars. In this very first year of its commercial production, it
purchased/imported materials from its parent company and associate concerns
2.
Assessee advance following arguments before Tribunal
a) Assesse is new company and comparable are
well established companies
b) Assets and depreciation profile of assesse
is sufficiently on higher side
c)
Accounting
policy adopted by assesse results in being technical know being written off
over a period of 3 years.
d)
The
TPO further requisitioned the financials of the comparable relating to the
periods of their incorporation and subsequent two years to prove that even they
were reporting losses in that period. The assessee regretted the inability to
do so as the relevant data are not in public domain. It was also submitted that the economic conditions, marketing
conditions and laws pertaining to that period would be totally different
vis-a-vis the conditions prevailing in the relevant period and this fact would
also make the comparison meaningless. It was also submitted that in view of the
technological advancements, which have huge impact on the price and profitability,
it does not make sense to compare data of the assessment years in question
vis-à-vis the data for a period of over a decade ago
Here explanation is appended
on geographic location of Market, which includes the concept of Location Saving
Geographical location of market
Market prices for
the transfer of the same or similar property may vary across different
markets owing to
cost differentials and/or differences in purchasing power and habits prevalent
in the respective markets which may affect the market price .
One of main
feature of Geographical Location of market having repercussion on Transfer
price is LOCATION SAVINGS.
Locational Savings and advantages
MNE may be
deriving significant locational saving
by shifting the enterprise from high cost location to low cost location.
It may also be
deriving other locational specific advantages as under:-
1.
Highly specialized skilled manpower and knowledge
2.
Proximity to growing local/regional market.
3.
Large customer base with increased spending capacity
4.
Advanced infrastructure (e.g
information/communication networks, distribution system)
5.
Market Premium
It may also
incurred additional cost on account of shifting to low cost country
The net benefit
to MNE is called locational rent.
The extent to which location specific advantages
(LSA) will lead to locational rent depends on competitive factors relating to
the end products and to general access to LSA.
It is possible
that in a particular case, even though LSAs exist, there are no location rents.
For example, in situations in which the market for the end product is highly
competitive and potential competitors also have access to the LSAs, much or all
of the benefits of LSAs would be passed on to the customers through lower
prices of products, resulting in little or no location rents. However, circumstances
where extra profits are passed on to customers are varied, and may be permanent
or temporary. Where this is temporary, at the end of this period of
competition, the MNE may possibly achieve a larger market share in the local
market with an increased ability to sell products at a higher price.
Alternatively, if an MNE has exclusive access to the LSAs, then the MNE may
derive significant location rents associated with the LSAs, as the LSAs reflect
a competitive advantage. These location rents may dissipate over time due to
competitive pressure, depending on the facts and circumstances of each case.
Further arm’s length
attribution of location rents depends on competitive factors relating to access
to LSA and on realistic alternative
available to the associated enterprise given their respective bargaining power.
e)
Business Strategies
Business strategies would take into account many aspects of an
enterprise such as
1.
Innovation and new product development
2.
Degree of diversification
3. Risk Aversion
4. Impact of
existing and planned labour laws
5. Duration of
arrangement
6. Market share
Market share strategies can be divided into 3
categories:-
1.
Market penetration strategies
2.
Market expansion strategies
3.
Market maintenance strategies
All 3 market share strategies use two fundamental tactis;-
1.
Lowering the price of products on temporary basis by
offering discount on the products to become extremely competitive in the
market.
2.
Increasing their marketing and selling expenses
through increased advertisement; sales promotion activities like offering
rebates, free samples, offering extended warranties etc. and increased
marketing activities like more salesmen, commission agents or distributors and
increased payments of commission to distributors\
Issues involved – Marketing
strategies-
1.
Allocation of cost
2.
Creation of marketing intangibles
Allocation of cost
It is important to examine the following factors for allocation of cost
between associated enterprises:-
1.
Which entity is initiator of strategy
2.
Which entity is intended beneficiary of the strategy
3.
whether unusually intense advertising, marketing and
sales promotion efforts are taking place since these would provide a signal of
market penetration or market share expansion strategies
4.
The nature of the relationship between related
parties, i.e. their responsibilities and risk profile
5.
Whether the strategy involves intangibles
6.
Which party is the legal and economic owner of such
intangibles
Marketing intangibles
1.
When MNE enters a new market with its product or
expand market share of its product in an existing market through its subsidiary,
questions of the creation of marketing intangibles and increases in the value
of product‐related intangibles such as trademarks, trade names etc. follow
closely behind
2.
Therefore, it is quite important to examine and
follow the process of creation of intangibles in a market, as well as the legal
ownership of that intangible and the right to share in the return from that
intangible (the notion which some countries refer to as “economic ownership”).
3.
It is recognised that market research; designing or
planning products suitable to market needs; advertising; marketing and sales
promotion strategies; after‐sale services and networks of dealers and
sales/commission agents may contribute to the creation of marketing intangibles
depending on the facts and circumstances of each case
POST
COMPARABILITY FACTORS ANALYSIS
Analysis of 5
comparable factor should culminate in the determination of the following:-
a) Tested party- The tested party should normally be the least complex
party to the controlled transaction and should be party in respect of which the
most reliable and data for comparability is easily and readily available.
b) Preliminary decision on transfer Pricing Method applicable based on
respective features, strengths and weakness of each of the methods.
c) Development of search criterion for identification of comparable
Here two aspects (S.No b & C) are further
detailed as under:-
Preliminary decision on Transfer Price Method.
Section
92C prescribed following six methods to arrive at ALP
i)
Comparable Uncontrolled Price Method
ii)
Resale Price Method
iii)
Cost Plus Method
iv)
Profit Split method
v)
Transactional Net Margin Profit
vi) Other Method
which takes into account price which has been charged or paid or would have
been charged or paid, for the same or similar uncontrolled transaction, with or
between non-associated enterprises, under similar circumstances, considering
all relevant facts
Each of method its own features and most suitable in
particular set of circumstances
The suitability of
each TP methods under various scenarios are as under:-
i)
Comparable
uncontrolled Price Method
a) One of the associated enterprises involved is engaged in comparable
uncontrolled transaction with an Independent enterprise.
b) Transactions involve commodity type products, but only those in
which product differences are negligible.
c) When products being transacted are commodities with relatively
limited value add and have objective quality measure that can be easily
determined.
d) Interest rate charged on Inter-company loan.
e) Royalty
ii)
Resale Price Method
a)
Most appropriate where tested party is engaged in pure
reselling operation
b)
Application of RPM required that reseller does
not make any material alteration to the products traded.
c)
In a typical intercompany transaction involving
a fully‐fledged manufacturer owning valuable patents or other intangible
properties and affiliated sales companies which purchase and resell the
products to unrelated customers, the resale price method is a method to use if
the CUP method is not applicable and the sales companies do not own valuable
intangible properties.
iii)
Cost
Plus Method
a)
The CPM is useful for long term buy and supply
agreements, pricing of semi-finished goods, toll or contract manufacturing,
services of purchasing agent, contract research and development &
intra-group provision of services.
b)
CPM is typically applied on controlled
transactions involving a contract manufacturer which does not own product
intangibles and obtains instructions from related customer about the quantity
and quality to produce.
c)
CPM is not suitable method to use in transaction
involving a full- fledged manufacturer which owns valuable product intangible
as it will be very difficult to locate independent manufacturer owning
comparable product intangible
iv)
Transactional
Net Margin Method
a)
When two related parties are engaged in
continuous series of transaction and one of the parties control intangible
assets for which arms length return is not easily determined
b)
If data on Gross margins are less reliable due
to difference in the treatment of certain cost as COGS or operating expenses
between tested part and comparable company
c)
Where the available comparables differ
significantly with respect to products and functions in order to reliably apply
the cost plus or resale price method, it may be more appropriate to apply the
TNMM, because net margins are less affected by such differences. Difference in
function performed may also affect the Net Margin, but still there will be
similar level of Net profit indicator, if proper denominator is used. Hence
TNMM may be used in this case
India’s Transfer Pricing
provisions do not any hierarchy or preference for Transfer Pricing methods. But
in recent judgement in Serdia Pharmaceutical, Mumbai tribunal that traditional
transaction method (CPU, RPM, CPM) have an inherent edge over the traditional
profit methods(PSM & TNMM) in most of the situations, and, therefore,
wherever both the methods can be applied in an equally reliable manner,
traditional transaction methods are to be preferred over traditional profit
methods
Development of Search
Criterion. This stand is to further test the waters with higher judicial
authority.
Comparable Search Criterion
In order to sustain the
Transfer Study before AO, it is essential that process of identification of
comparables should not be random rather based on proper criterion
developed after proper FAR analysis.
In order to develop, search
criterion for identification of comparables,
following factors should be considered:-
1. Specific Industry classification.
2. Geographic restrictions with
regard to a country or region
3. Eliminate all those enterprise which may have transfer pricing
issue.
4. Include or exclude specific functions such as research and
development, production, distribution and holding of shares
5. Exclude companies which are recently set up.
6. Quantitative filters with regard to Turnover.
7. Consider ratios such as turnover per employee, ratio of Net value of
intangibles/Total Net Assets value or Ratio of R&D/Sales, Manufacturing
sales/Total sales, Trading sale/Total Sales, Advertising/Sales.
8. Focus on sales volume or a fixed assets or number of employees.-This
will idea about the scale of operations.
9. Intangible-related criteria such as Net Value of Intangibles/Total
Net Assets Value, or ratio of
R&D/Sales where available:
they make it
possible for instance
to exclude companies
with significant intangibles
or R&D activities
when the tested
party is a
contract manufacturer which does not own
significant manufacturing intangible
nor participate in R&D
10.
Criteria
related to the
importance of export
sales (Foreign sales/total
sales), when relevant
11.
Criteria related
to inventories in
absolute or relative
value: they can
be used, for
instance, to
specifically search for
manufacturers with no
inventories when the
taxpayer is a toll manufacturer that does not take title of inventories
6.
Comparability Adjustments
·
Need for
Comparability Adjustments
a)
Transfer Price study involves comparison of
conditions of Controlled transactions with uncontrolled Transaction
b)
However in reality controlled and uncontrolled
are not similar on every material ground.
c)
There arise a need to make certain adjustments
in uncontrolled transaction to make is comparable with Controlled Transaction. Further all these adjustments are made in
uncontrolled transactions to make them comparable with controlled transaction.
·
Issues to
be considered for Comparability Adjustments
a)
Materiality
– The differences that have no material effect on comparability (Price or
margin) should not be adjusted.
b)
Quality
of Data being adjusted – The adjustments should be carried on uncontrolled
transactions which are fairly comparable with controlled transaction, except on
some aspects which can be overcome through adjustments. Too many adjustments to
uncontrolled transaction may indicate that uncontrolled transaction in itself
is not sufficiently comparable with controlled transaction.
c)
Reliability
– The adjustments should be carried out based on objective and verifiable data
d)
Documentation
- comparability adjustments are part of comparability analysis and should be
appropriately documented in order to ensure its reliability. Among other things
documentation should cover the following:-
i)
Reason for adjustment being considered
appropriate
ii)
How adjustments are calculated
iii)
How adjustments changed the results for each
comparable and how adjustments improve comparability.
·
Categories
of Comparability Adjustments
a) Accounting adjustments
b) Balance sheet Adjustments
c) Functional adjustments
a)
Accounting
Adjustments – These type of adjustments are generally carried out, when
either of RSP, CPM or TNMM method is proposed to be used. All these method
involves determination of a RATIO either Gross Margin or Net margin etc. The
RATIOS are arrived on the basis of data in financial statements and these
statements are based on set of accounting policies which differ from one entity
to other. In order to ensure that results of two entities (Tested party and
Uncontrolled party) are comparable, it is necessary that their financial
statements are drawn on same set of policies. Thus based on TP method propose
to be used, those accounting adjustments are carried out in uncontrolled
adjustment which has material effect on ratio to be used for comparability.
i)
Resale Price Method –
·
Revenue Presentation – One entity is showing
Sale expenses as deduction from sales & other entity is showing as a part
of operating expenses. Revenue should be adjusted for comparability
·
Stock Valuation - If difference in stock
valuation has material effect on GROSS MARGIN comparability , necessary
adjustments are required
ii)
Cost Plus Method – Ensuring the components of
direct and indirect operating expenses are on common basis and if not,
necessary adjustments are required.
iii)
Transactional Net Margin method – In Capgemini
India (P) Ltd- ITA No. -7861/Mum/2011,A/Y – 2007-08, Mumbai Tribunal held that ESOP expenses debited in P&L was held to
be extra-ordinary expense while applying TNMM method.
b)
Balance
sheet adjustments- These adjustments too are required when one proposed to
use either of RSM, CPM or TNMM method.
·
These adjustments are intended to account for
different level of inventories, trade payable, trade receivable i.e working
capital
·
A significant different level of asset intensity
may require further investigation of the comparability characteristics of the
potential comparable and merely making a working capital adjustment would not
alleviate the problem.
Difference
in level of working capital has direct repercussion on operating profitability.
An entity may give more credit period to its customers but charging higher
price as compared to other entity. Thus former entity having high receivable is
also earning more profit as compared to latter entity. Thus it is necessary to
carry our working capital adjustment to ensure comparability of tested party
with uncontrolled party.
Illustration - Refer below mentioned illustration in case
where TNMM method is propose to use and working is done in two scenarios;-
i)
Where NP Margin is used as PLI
ii)
Where GP/Operating expense is used as PLI
| Particulars |
Tested |
Uncontrolled |
| Rs. |
% |
Rs. |
% |
| Sales |
100 |
|
200 |
|
| Purchase |
60 |
60% |
118 |
59.00% |
| GP |
40 |
40% |
82 |
41.00% |
| Operating Exp |
36 |
36% |
72 |
36.00% |
| NP |
4 |
4% |
10 |
5.00% |
| Debtors |
50 |
|
120 |
|
| |
|
|
|
|
| If PLI- Net margin |
|
|
|
|
| Debtors/sales |
50% |
|
60% |
|
| Excess Debtors (A) |
|
|
10% |
|
| Rate of Interest (B) |
|
|
10% |
|
| Adjustment (A*B) |
|
|
1.00% |
|
| Adjusted NP Rate (Uncontrolled NP Margin- Adjustment) |
|
|
4.00% |
|
| |
|
|
|
|
| If PLI- GP/Operaing expenses |
|
|
|
|
| GP/Op exp |
|
111.11% |
|
113.89% |
| Debtors/Op Exp |
|
138.89% |
|
166.67% |
| Excess Debtors (A) |
|
|
27.78% |
|
| Rate of Interest (B) |
|
|
10% |
|
| Adjustment (A*B) |
|
|
2.78% |
|
| Adjusted GP/Op Exp (Uncontrolled GP/Op Exp- Adjustment) |
|
|
111.11% |
|
c)
Functional
Adjustments
i)
There can be difference in mix of functions
performed by tested party and uncontrolled party
ii)
Such functional difference if not adjusted, may
affect the reliability of comparable in establishing Arm’s length price range
iii)
To eliminate the effect of functional
difference, financial results of comparable need to be adjusted.
iv)
An adjustment is made to the revenue and costs
relevant to the functions performed by the comparables but not by the tested
party
