Mr. Rajiv Kumar Singh, IRS (IT: 1993)
CIT (A)-1 Raipur
kumarsritd@gmail.com
Shri Rajiv Kumar Singh belongs to the 1993 batch of the IRS and is currently posted as Commissioner of Income -tax (Appeals) at Raipur in the state of Chhattisgarh. He is an MBA and has recently done a LLM in international tax laws from Kings College, London. The officer has worked at various levels in assessment, corporate, investigation, and in the appellate charges in the department. He delivered lectures as guest faculty on various provisions of the Income-tax Act to the LLB students at Hidayatullah National Law University, Raipur.
Executive Summary
Transfer Pricing provisions in Chapter X of the I-T Act 1961 entitled Special Provisions Relating to Avoidance of Tax enables the Transfer Pricing Officer in determining the Arm’s Length Price (ALP) in relation to an international transaction between Associated Enterprises commonly referred as controlled transaction, by using the Most Appropriate Method (MAM) from the prescribed methods under Section 92C (1) of the Act. This article examines the traditional methods such as Comparable Uncontrolled Price Method (CUP), Cost Plus Method (CPM) and Re-sale Price Method (RPM) known as direct methods, their relative strengths and weaknesses, conditions and circumstances in which they are applied in determining the ALP. The importance of Functions, Assets and Risks (FAR) have been underlined in the selection of comparables and their impact on comparability analysis. Importantly, the influences of the OECD and UN transfer pricing guidelines have been discussed along with the areas of differences in approach with the provisions of the I-T Act 1961. Analysis undertaken are supported by judicial pronouncements of various courts including that of other countries. The article suggests that accuracy of comparability analysis in determining the ALP is enhanced by a clear understanding of the controlled transactions, right selection of comparable cases, and by adopting the most suitable or appropriate method.
In this article, we examine the traditional transaction methods in Transfer pricing such as Comparable Uncontrolled Price Method (CUP), Re-sale Price Method (RPM) and Cost Plus Method (CPM), their utility, strengths and constraining factors in their application. For making a comparability analysis, which is the core for arriving and applying the Arm’s length Principle, we have touched upon the importance of products, functions, assets and risks in similar circumstances of the comparable entity selected for the analysis. The impact of the OECD and UN transfer pricing guidelines on the TP provisions in India have been discussed along with the differences in approach. Observations and analysis made are supported by case laws on specific issues, which have helped in fine-tuning the clarity and application of the traditional methods. The article is illustrative and by no means exhaustive on the subject and will be followed by the second part dealing with transactional profit methods.
Transfer pricing was introduced by the Finance Act 2001 and came into force from April 2002. It appears in Chapter X of the Income Tax Act 1961(theAct)entitled‘SpecialProvisionsRelating to Avoidance of Tax’. Though the title of the chapter relates to avoidance of tax, the Assessing Officer is required to examine the international transactions between the associated enterprises (AEs) and not avoidance of tax as was held by the Bangalore Special Bench in the case of Aztec Software & Technology Services (107 ITD 141 for referring the case to the Transfer Pricing Officer (TPO) for determining the Arm’s Length Price (ALP) of the transaction under Section 92CA (1) of the Act. Transfer pricing provisions enables the assessing authorities to examine the price paid for goods and service between related enterprises in a controlled transaction (in their commercial or financial relations) by using the prescribed methods for determining the Arm’s Length Price of the controlled transactions. The ALP refers to the price which is applied or proposed when unrelated or independent enterprises enter into similar transactions under market conditions or uncontrolled conditions. The Arm’s Length Principle follows the approach of treating the members of a MNE group as operating as separate entities, as if they were independent entities rather than constituents of a single unified business and focusing on the nature of transactions between them and whether the conditions differ from the conditions that would be seen in comparable uncontrolled transactions. A comparability analysis remains the key for determining and applying the ALP and must take into account Functions, Assets and Risks (FAR) which must be the same under similar circumstances of the comparable entity selected for making the comparability analysis. In some methods, the product similarity assumes significance in addition to the FAR, as we shall see below. There are two broad categories of methods, Traditional transaction methods and Transactional profit methods for determining the Arm’s Length Price between associated enterprises in a controlled transaction. We examine the traditional transaction methods in this study.
The Comparable Uncontrolled Price method (CUP), Resale Price Method RPM) and the Cost Plus Method (CPM) are regarded as the traditional transaction methods. The OECD regards them as the most direct means of establishing whether the conditions in the commercial and financial relations between associated enterprises are at Arm’s length1. The 1995 OECD Transfer Pricing Guidelines preferred the traditional transaction methods over the transactional profit methods2 such as the Transactional Net Margin Method and Transactional Profit Split Method and treated them as methods of the last resort but in 2010 this hierarchy was eliminated and replaced by the principle of Most Appropriate Method (MAM) to the circumstances of the case.3 However, the OECD prefers the CUP method over the others if applicable in an equally reliable manner.4
On the other hand, the UN Manual on Transfer Pricing does not accord preference for particular methods,5 it lays down that the most suitable method should be chosen taking into considerations facts and circumstances, type of transaction, functional analysis, comparability factors and possibility of making adjustments to the data to enhance comparability.6 In the Transfer Pricing provisions in India, the ALP must be determined by the MAM as prescribed under Section 92C of the Act read with rules 10B of the Income-tax Rules and CBDT Circular No. 6/2013 of 29 June 2013. Similar to the UN Transfer Pricing guidelines, the Transfer Pricing Provisions in India do not emphasize the use of any particular method over the other, no hierarchy of methods is prescribed but place the burden on the taxpayer to select the MAM,7 by furnishing comparable transactions and relevant material and documents,8 the selection of the method must be justified on some sound reasoning and must demonstrate that the method so selected is the most appropriate.9 There is no need to demonstrate why other methods are eliminated because once a method is selected as the MAM, some methods will be easily eliminated as not being the MAM based on simply a high level analysis of the comparability factors10 on a transaction basis and not on aggregate basis and comparing the margins of associated enterprises with that of unrelated enterprises.11 Recently, in most of the Transfer Pricing study reports the taxpayers are enumerating their reasons for preferring a specific method and also explain why other methods are unsuited. However, when the taxpayer has chosen a MAM and has substantiated the choice in its TP study, the onus is on the TPO to record and substantiate reasons as to why the taxpayer’s MAM is incorrect and some other method needs to be the MAM.12 In various tribunal decisions, which are quoted herein, preference have been accorded to the traditional methods as they are considered to give the most reliable results over the transactional profit methods.
COMPARABLE UNCONTROLLED PRICE METHOD (CUP)
The CUP method compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances.13 The price difference or variation may be an indication that transactions amongst the AE’s are not at the Arm’s Length and may require adjustments to adopt the price in the uncontrolled transaction replacing that in the controlled transaction. In making the comparisons under this method, it is not only the nature of product which has an impact on the quoted price but also broader business functions, markets, economic conditions as these factors affect the prices of products and services. In the Income-tax Rules 1962, CUP is explained in rules 10B read with Section 92C of the Act and is identical to the OECD Guidelines in taking the price of a comparable uncontrolled transaction (with adjustments, if necessary) to account for price difference. The selection of comparables and making adjustments at both product and functional level under CUP requires precision which is the main reason for higher accuracy and reliable results in this method.
The analysis can be further strengthened by carrying out an internal CUP comparability and external CUP both are of equal importance.14 In the Canadian case of Alberta Printed Circuits, the court examined the external CUP to test Internal CUP in arriving at the benefits test for the services rendered.15 In the case of Mattel Toys (l) (P) Ltd vs. Dy. CIT, the Mumbai tribunal held that where internal comparables are available they are preferred over external comparables.16 The reason is that under internal CUP the controlled and uncontrolled transaction of the same taxpayer is taken which provides reliable data for price comparability. If the price charged in the controlled transaction is less than that being charged in the uncontrolled transaction, no adjustment may be necessary in making analysis in CUP. Significantly, the CUP method dispenses with the requirement of a tested party17 irrespective of legal and economic ownership of valuable intangibles, which can be comparables themselves for the ALP analysis.18 Internal comparability which is common to the traditional methods is preferable over the tested party, which is an important aspect of Transactional Profit methods such as Transactional Net Margin Method, as the latter method will require further analysis in identifying the least complex party, free from ownership of valuable intangibles and other factors of comparison. This is the reason for the recommendation of traditional methods over the transactional methods by the OECD guidelines and the courts in India.
LIMITATIONS AND IMPACT ON ANALYSIS
In a study of cases in which CUP method has been employed in India, it is seen that the selection of comparables have been held to be not satisfactory whereby the tribunals have remitted the assessment back to the TPO for filtering the comparables and undertaking a comprehensive functional analysis. This highlights one of the weaknesses of the CUP that adequate and relevant data in the public domain may not be available for a comparability analysis and if available the genuineness, reliability of data itself may have to be tested. As CUP is price sensitive, even a minor product/ functional difference of the comparable may give unreliable results which have been highlighted by the courts and tribunals in the decisions on TP adjustments. It was held that CUP method cannot be applied where there were different geographical, volume, market conditions,19 separate timing of order,20 and unsuited if there are material product differences or where substantial adjustments were required,21 where there are separate comparable days of contract of sale,22 even if same products are sold to resident AEs it cannot be taken as benchmark for ascertaining ALP of its similar sale transaction with non-resident AEs.23 In the Canadian case of Glaxo-SmithKline,24 failure to consider the license agreement which required purchase of Ranitidine from Glaxo approved sources rendered the assessment using the CUP method disapproved by the Supreme Court and was remanded to the tax court for redetermination. Here, the contractual agreement alone was the cornerstone of the whole transaction which impacted the price.
Often, the data required for undertaking a comparability analysis is complex that may require filtering which along with related documentation may be burdensome for the taxpayer. It is often time consuming and difficult, expensive, and a laborious exercise both from the perspective of the taxpayer and tax administration. The OECD guidelines and UN Manual do not recommend abandoning CUP merely because comparable data is not available, but as solution suggest broadening the search criteria including the possibility of using hybrid or external sources or taking a deductive or additive approach. However, taking such approach in the Indian context would require a higher comparability analysis by increasing the filtering process of unrelated external ratios which impact price and as a consequence will increase the compliance burden.
Since the primary purpose of Transfer Pricing in India is influenced by Article 9 of OECD and UN Model Convention to prevent tax avoidance, some TP adjustments have been made by using secret comparables which, even if not in the public domain, can be thrust upon the taxpayer in the CUP method as was held by the Ahmedabad Tribunal in Dy. CIT vs. Hazira LNG (P) Ltd.25 However, highlighting the importance of transparency from the perspective of the taxpayer and tax administration, the OECD guidelines note that the use of secret comparables not in public domain by the tax administration will be unfair.26 Against the use of secret comparables, the UN Transfer Pricing Manual states that taxpayers contend that the use of such secret information is against the basic principle of equity and it would be unfair if they face the consequences of adjustments made on this basis, such as additions to income typically coupled with interest, penalties etc.27 Because of the lack of data in making a comparability analysis in the CUP method, inclination for selecting other methods which are not so product sensitive and do not require many comparables are commonly seen in the orders of the TPO.
RESALE PRICE METHOD (RPM)
The Resale Price Method appears in Rule 10B(1)(b) of the Income-tax Rules, and to put it simply, is the price at which the property purchased or services obtained by an entity from an AE is resold, or provided to an independent enterprise. The resale price is reduced by the gross profit margin from the purchase and resale of the same or similar property or services in a comparable uncontrolled transaction, the price so arrived is further reduced by the expenses incurred by the entity for the purchase of property or obtaining services. The price arrived at is adjusted to account for functional differences if any, including accounting practice, if any, between the international transaction and the comparable uncontrolled transaction which impact the gross profit margin in open market conditions. The adjusted price arrived at is the ALP for the purchase of property or services, as the case may be. It can be observed that a step-wise reduction of expenses at different stages is crucial in arriving at the ALP.
SIMILARITIES AND DIFFERENCE IN METHODOLOGY
The methodology prescribed in the Act is similar to that outlined by OECD guidelines. However, this method differs from the CUP as minor product difference is less likely to have an impact on the profit margins, although in making a comparability analysis it is the product or property transferred which must be compared. The RPM thus focuses on functional comparability and its strength lies in being a demand driven method in a B2B business segment because the resale price is the market price with less scope of artificial profits and losses by distributors other than an arm’s length gross profit margin. Another difference with the CUP method is that in the RPM method, the resale price margin can be determined by an internal comparable which is different from the internal CUP (reseller purchasing and selling in a comparable uncontrolled transaction) and external comparable (resale price margin of an independent enterprise). It is the same or identical product or services from the point of purchase to resale requiring fewer adjustments to account for product differences; the method renders better results when the purchase and resale are within a short span of time because with the lapse of time the changes in market conditions and economic factors will impact comparisons.
Even if the resale of products and services take place in accordance with the global price list, a comparability analysis, which remains the core of TP analysis, is indispensable while adopting the RPM. The Mumbai tribunal in the case of Kodak Polychrome Graphics (I) (P) Ltd v Addl. CIT held that where the taxpayer made no comparability analysis while adopting resale price method, purchase transactions could not be held to be at ALP simply because AE supplied products at global price list.28 Lack of comparables and relevant data in the public domain on gross margins can affect the RPM method, importantly accounting consistency is a vital consideration for the accuracy of this method as the transactions involve purchase and resale of products and services, any unrealistic bench marking of the gross profit margin can lead to skewed result between the supplier and distributor, the former would be shown in a loss but the latter in profit. Since functional comparability is the core of RPM, the reliability of RPM may be affected if the independent enterprise chosen for comparability has different business synergies and there are functional differences. This is because the RPM takes into account gross margins and any material or functional difference in the business of the comparable entity will impact the margin and render the comparison erroneous. In Abott Medical Optics (P) Ltd vs. DCIT, the Bangalore tribunal upheld the action of the TPO in rejecting the RPM on the ground that the business model of the taxpayer was not comparable with that of comparable companies as they were not incurring such expenditure on selling, distribution, and sales promotion.29 Delay in resale or value addition to the product by the reseller may render the RPM unsuitable and may require choosing another method for comparability and reliable results as each method requires different comparability ratios of controlled transactions. Though adjustments can be made, but at the cost of time, documentation, and broadening the search. For applying a method the starting and ending points of a transaction assumes significance and where the transaction halts at a transit point, such as value addition, the transaction becomes unfit for applying the RPM.
COST PLUS METHOD (CPM)
The Cost Plus Method (CPM) begins with the costs incurred by the supplier of property or services in a controlled transaction for the property transferred or services provided to an AE.30 An appropriate cost plus mark-up is added to this cost to arrive at an appropriate gross profit in the light of the Functions Assets and Risks and market conditions. In this method the same principles of RPM apply in determining whether a transaction is a comparable uncontrolled transaction, fewer adjustments may be necessary on account of product differences, more weight is given to material and functional comparability as this method is benchmarked on gross profit margins. The CPM is a useful method in cases of contract manufacturing or contract services, toll manufacturer, inter-company sale of intangible property and with the right choice of comparables reliable results can be obtained. This method is outlined in Rule 10B (1)(c) of the Income-tax Rules 1962 and as can be noticed, resembles the description provided in the OECD guidelines.
UNIQUE FACTORS OF COMPARABILITY
The emphasis in the Income-tax Rules 1962 for both RPM and CPM is on functional analysis taking into account both direct and indirect production costs. But there are constraining factors in proper application of this method. The Income-tax Rules and the OECD guidelines lay down that same accounting practice of the entity selected as a comparable is important as any difference in the accounting practice with different reporting standards can affect the gross profit comparable margins. In Essilor Manufacturing India (P) Ltd vs. Dy. CIT, the tribunal rejected the CPM as the taxpayer sought adjustment on account of variation of depreciation method applied by it in comparison to comparables which itself showed that the cost components of the taxpayer were in variations with that of the comparables.31 The same situation applies where the assets are owned and if comparisons are made with an entity which has leased assets the result will be erroneous as the items charged to the profit and loss account will be different under the head ‘lease rentals’ for the latter and ‘depreciation’ in the former. Sometimes, the costs incurred may not impact the profit in a specific year and can be incubatory, that is affecting the profits in subsequent years and may require adjustments if not abandoning the comparable. While allocating costs, only those items both direct and indirect which have a link with the gross margins and the market price can be taken for comparability, but this exercise may require deeper scrutiny where the prices have been scaled down in relation to cost of production to compete in the market.
Neither the Income-tax Rules nor the OECD guidelines specify the methodology for applying the normal gross profit mark-up. This is dependent on the gross margins and the calculations made by the accounting standards which forms the basis of applying percentage on the gross margins. The OECD guidelines suggest that when applying the CPM, care should be taken to apply a comparable mark-up to a comparable cost basis.32 In this regard, although support can be taken from a functional analysis but similar to the CUP method and as held by the Pune Tribunal in Alfa Laval (I) Ltd vs. Dy. CIT, the segmental differences such as market functions, geographic difference, volume difference, credit risk, types of customers, product liability risk are crucial and may affect the FAR and create problems for the CPM and make it inapplicable.33 Under the traditional transaction methods, the functional analysis in comparable circumstances is the key though it is only in the CUP method that product similarity also is important. The strength of the traditional methods lies in making a comparable analysis at the product and functional level and these factors bring out the demand and supply of specific products and services and their price in open market conditions.
Before making the choice of methods the vital condition is to understand the nature of business transaction for example if the business is contract manufacturing of garments a CPM is useful, for purchase and resale of items such as SIM cards or mobile phones in which no value is added by the reseller the RPM is handy but where commodity transactions take place such as manufacturing and sale of coffee or raw material purchases the CUP method can be applied. Besides understanding the transaction it is necessary to examine the facts not so visible and if necessary subjecting a part of the transactions on the basis of those facts to a separate method. A case in this regard is the Delhi High Court judgment in Denso India Ltd vs. CIT 34 in which although the payment of royalty by the taxpayer was subjected to the Transactional Net Margin Method the assessing officer subsequently noticed that the taxpayer imported 85% of raw material not from the manufacturer but from an intermediary who was connected both with taxpayer and the manufacturer. The ALP was determined by taking the CUP method for the transaction pertaining to raw material procurement and was upheld by the court. This decision in which two methods have been approved on the facts of the case is a departure from the MAM approach.
Thus, the choice of methods for determining the ALP will depend on the nature of transactions considering the product and undertaking a FAR analysis. The selection of comparables is a vital step in making the analysis which requires judgment and understanding of comparable transactions and comparable circumstances.
Notes:-
1OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration, OECD 2017, [2.3]
2Ibid [2.49]
3Kofler G, “Article 9’ Associated enterprise” in Reimer and others (eds) Klaus Vogel on Double Tax Conventions (Wolters Kluwer 2015) p 653.
4Ibid.
5United Nations, Practical Manual on Transfer Pricing for Developing Countries (2017), [B.3.1.3.2]
6Ibid.
7Aztec Software & Technology Services Ltd vs. Assistant Commissioner of Income-tax [2007] 107 ITD 141 (Bang SB).
8Ibid.
9Serdia Pharmaceuticals (India) (P) Ltd v Asst CIT [2011] 44 SOT 391 (Mum Trib.).
10Kofler, op.cit. note n*3, p. 654.
11Development Consultants (P) Ltd vs. Dy. CIT [2008] 23 SOT 455 (Kol. Trib.).
12ITO vs. Alumeco Indian Extrusion Ltd [2013] 38 taxmann.com 382 (Hyd. Trib.).
13OECD, op.cit. note n*1 [2.14].
14Kofler,op.cit note n* 3, 644
15Alberta Printed Circuits Ltd and Her Majesty The Queen 2011 TCC 232 [201]-[212]
16[2013] 34 taxmann.com 203 (Mum Trib) [53]
17UN, op.cit note n*5, [B.3.2.3.1]
18Maruti Suzuki India Ltd v Additional Commissioner of Income-tax transfer pricing W.P. (C) 6876/2008
19Amphenol Interconnect India (P) Ltd v Dy. CIT [2015] 53 taxmann.com 83 (Pune trib) [5] – [7].
20Ibid [2015] 64 taxmann.com 424 (Pune Trib) [14]
21Qual Core Logic Ltd v Dy.CIT [2012] 22 taxmann.com 4 (Hyd. Trib) [39]
22Liberty Agri Products (P) Ltd v ITO [2011] 16 taxmann. com 174 (Chennai Trib) [8]
23Gemstone Glass (P) Ltd v Jt. CIT [2016] 156 ITD 176 (AhdTrib) [8]
24Canada v GlaxoSmithKline Inc., 2012 SSC 12 [51]
25[2017] 77 taxmann.com 61 [18]
26Kofler op.cit. note n*3, 645
27UN, op.cit. note n* 5 [B.2.4.8.3]
28[2013] 36 taxmann.com 42 (Mum Trib) [48]
29[2016] 71 taxmann.com 338 (Bang. Trib) [8]
30OECD, op. cit note n* 1 [2.45]
31[2016] 67taxmann. Com 377 (Bang. Trib) [4.4]
32OECD, op.cit. note n*1 [2.49]
33[2014] 46 taxmann.com 394 (Pune Trib.) [6.3]
34[2016] 68 taxmann.com 55 (Delhi)
Source- Taxalogue 3- April to June 2020
