CA Ram Bajaj
Introduction – The price charged usually reflects the function that each enterprise performs (taking into account assets used and risk assumed). Comparability analysis of the controlled transaction for the enterprises participating in the controlled transactions provides a basis for characterisation of the controlled transaction to be benchmarked or the characterisation of the tested party Therefore, comparison of the functions performed, assets used and risk assumed by the parties is necessary in determining whether the prices of controlled and uncontrolled transactions are comparable. . Thus, the first stage of comparability analysis in Transfer Pricing benchmarking exercise is to gather all the relevant facts and circumstances surrounding the controlled transactions under review.This exercise is known as Function, Asses and Risk (“FAR”) analysis. This analysis forms the basis and provides a framework for comparability study and subsequent determination of the most appropriate method. It assists in proper assessment of comparability for the purpose of Arm’s length study.
Rule 10B of Income Tax Rule
Rule 10B(2) states that for the purpose of determination of the Arm’s Length Price, the comparability of an international transaction with an uncontrolled transaction shall be judged with reference to the following, namely:—
1. the specific characteristics of the property transferred or services provided in either transaction;
2. the functions performed, taking into account assets employed or to be employed and the risks assumed, by the respective parties to the transactions;
3. the contractual terms (whether or not such terms are formal or in writing) of the transactions which lay down explicitly or implicitly how the responsibilities, risks and benefits are to be divided between the respective parties to the transactions;
4. conditions prevailing in the markets in which the respective parties to the transactions operate, including the geographical location and size of the markets, the laws and Government orders in force, costs of labour and capital in the markets, overall economic development and level of competition and whether the markets are wholesale or retail.
Rule 10B(3) lays down that an uncontrolled transaction shall be comparable to an independent transaction if—
1. 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
2. reasonably accurate adjustments can be made to eliminate the material effects of such differences.
Court Judgement For FAR Analsysis
The Supreme Court in the case of Morgan Stanley and Company Inc. [292 ITR 416] emphasized on FAR analysis (analysis of the functions performed, and associated resources employed, by the taxpayer in the controlled and uncontrolled transactions) for benchmarking exercise for determination of arm’s length price of an international transaction.
Hoganas India (P.) Ltd. V. Dy. CIT [2013, 30 taxman.com, 390]
in respect of a matter, where the parent company received commission at the rate of U.S dollars 30 per MT on sales directly made to parent company in India, which worked out to 1.49% of the corresponding sales achieved by parent company in India. TNMM was adopted for determining arm’s length price and comparison was made by commission received by assessee for marketing its own product in India showing that it was not on par with standard rate of commission received for distribution of parent’s products.
Since the internal rate of return attributable to marketing function was 4.44%, an addition of difference of 1.49% was added by the TPO. It was found that in view of the difference between parameters of risk involved in distribution of parents products and own products, the benchmark adopted by TPO was found unacceptable.
Wrigley India (P.) Ltd. V. Addl. CIT [2011]
where in case of a business of manufacturer and selling confectionary products by the Indian company to its associated enterprises in the Middle East and Spain, TNMM was adopted, but the Transfer Pricing officer preferred cost plus method on the comparison of domestic segment with export segment, which was challenged, on the allegation of significant dissimilarity between these two segments. The tribunal, however held that FAR profiles of both segments were of same nature with commonality of manufacturing and administrative infrastructure with no substantial product difference. The tribunal, therefore allowed relief to the extent of 4%, which was based on relative profitability more by way of thumb rule deviating from its own working of FAR profile. Geographical location was also not given due weight, besides the differences arising in matters of business development, sales promotion, advertising and marketing, maintaining distribution network, inventory management and realisation of debts involving credit risk.
Pune Bench of the Tribunal in the case of E-Gain Communication (P) Ltd. vs. ITO : 118 TTJ 354, After analyzing the position in this regard under the Indian Transfer Pricing Regulations, US Regulations and also OECD Guidelines, held as under:
“37. It is clear that even when TNMM method is applied to determine arm’s length price as per OECD guidelines, functional profile, assets, assumed risks of controlled and uncontrolled transaction are to be seen while screening. Besides, it is not possible to ignore specific Indian regulations on the subject. We have already noted the relevant rule (2) and (3) 10B of I.T. Rules, which specifically require to consider for comparison “the functions performed assets employed and risks assumed by respective parties” In Rule 10(B)(1)(c) of I.T. Rules providing for determination through TNMM, it is clearly provided in clause (iii) “the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the difference if any”. These regulations have force of law and notwithstanding OECD guidelines, the T.P.O. cannot refuse to consider specific characteristics of transaction, functions performed and assets employed as has been done in this case……….”. It is thus evident from above that both OECD guidelines and US regulations insist on necessary adjustments for difference on issues affecting profitability. The transactional net margin method may afford a practical solution to otherwise insoluble transfer pricing problems if it is used sensibly and with appropriate adjustments to account for differences of the type referred to above. Similarities and dissimilarities of the transactions under comparison are to be scrutinized to see differences of situations, circumstances and environment. Any difference which materially affects the market value is to be given aserious consideration. The degree of comparability between the tested party and the uncontrolled taxpayer with parameters like nature or line of business, product or service market, the assets composition employed, the size and scope of operation, the stage of business or product cycle are required to be seen. In case of uncontrolled entity, operative income attributable to assets other than assets under consideration is to be adjusted before taking transaction for working mean margin of profit. Income and expenses of the segment of total business may have to be considered. Depending on facts and circumstances of the case, It may also be appropriate to adjust the operative profit of tested party and comparable parties . “
COMPARABILITY FACTORS
The US Regulations set forth four nonexclusive comparability factors to be considered in determining comparability and the extent to which adjustments are necessary, viz
(1) Functions,
(2) Assets
(3) Contractual terms;
(4) Risks;
(5)Economic conditions
and The OECD Guidelines, too, lists similar comparability factors.
However, the OECD Guidelines includes risks as part of functional analysis.
1. Functions: ‘Functional analysis’ is finding and organizing facts about a business in terms of its functions performed, risks and tangible and intangibles, assets utilized in order to analyse how these are allocated between the companies involved in the transactions under review. Functional analysis must identify and compare them. These are the example of function performed by enterprise
A. Manufacturing
B. Procurement
C. Quality Control
D. Inventory Management
E. Sales
F. After Sales Support
G. Research & Development
H. Marketing
I. Administration etc
2. Assets :- Assets has very huge impact in comparability Analysis. A company having higher assets can get benefit in market in terms of price charged in comparable of company having low assets. Assets may include all type of assets as under mentioned. In simple words, Infosys is leader in IT Industry. It has huge assets base in all segment in tangible assets as well as intangible assets. A new company in IT cannot be campared with Infosys for TP study because both assets are not matchmaking or not at all at level of comparsion.
1. Tangible Assets
•Building
•Office Equipments
•Vehicles
•Computers etc.
2. Intangible Assets
•Patents
•Technical Know-how
•Goodwill
•Trademark etc.
3. Contractual Terms: A comparison of significant contractual terms is required in comparing controlled and uncontrolled transaction. The Regulations specify nonexclusive contractual terms that could affect the comparability of the controlled and uncontrolled transactions –
1. the form of consideration charged or paid;
2. sales or purchase volume;
3. the scope and terms of warranties;
4. rights to updates, revisions or modifications;
4. Risks: In determining the degree of comparability between controlled and uncontrolled transactions, it is necessary to compare the significant risks that could affect prices or profits. The Regulations specifically identify categories of risk –
1. market risks, including fluctuations in cost, demand, pricing and inventory levels;
2. risks associated with R&D;
3. financial risks (including currency and interest rate risk);
4.credit and collection risks;
5. Economic Conditions: The Regulations identify significant economic conditions that can affect prices or profits:
1. the similarity of geographic markets;
2. the relative size of each market and its level of economic development;
3. the level of the market;
4. the applicable market shares for the relevant products, properties or services;
5. the location-specific costs of production and distribution;
6.the extent of competition in each market for the relevant products or services;
Manufacturing intangibles are characterized as one of two types –patents or non-patented technical know-how and arise out of either R&D activity or the production engineering activities of the manufacturing plant.
CONCLUSION
For undertaking an undisputable benchmarking exercise for determination of arm’s length price of international transaction, it is imperative both for the tax payer as well as Transfer Pricing Officers to go through the arduous process of investigation and understanding of the facts surrounding the inter-company transactions by undertaking a systematic functional analysis. This may involve interviews, examination of documents and understanding of business to obtain in-depth information regarding functions, risks and intangibles of each legal entity. This may identify further areas for review, including relevant contracts and financial data. Industry associations and publications may also be consulted to understand standard operating practices within the industry as well as the key value drivers involved in the transaction.
(Author can be reached at Mobile- Mobile-09461574223 and email- rambajaj.co@gmail.com)
Very informative analysis Sir