Transfer pricing has become the most significant source of litigation in India and is increasingly becoming a regular discussion point in the board room of large Indian and Global Multinational enterprises (“MNEs”). Indian Tribunals have issued around 650 rulings over the past decade on transfer pricing issues, setting precedents for taxpayers on a wide range of issues.
In dealing with two independent enterprises, the price charged usually reflects the function that each enterprise performs (taking into account assets used and risk assumed). 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. 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 the Income Tax rules require a functional analysis to determine whether controlled and uncontrolled transactions are comparable as well as to establish a factual standard on the basis of which adjustments may be made to the results of comparable transactions or companies. A functional analysis in most cases is an essential tool for finding and organising facts about a business in terms of its functions, risk and intangibles. Functional analysis identifies how the economically significant activities undertaken by a multinational are divided between each member involved in the transaction under review, for which respective members should expect to be rewarded.
Economic theory predicts that the enterprise that provides most of the effort, and more particularly, the rare or unique functions, should earn most of the profit. Further, in the open market, the assumption is that increased risk will be compensated by increase in expected return. An appraisal f risk is therefore important in determining ALP.
Landmark judgements relating to Importance of FAR
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. The Benches of the Tribunal have also laid emphasis on a systematic functional analysis for determination of arm’s length price of international transaction.
Importance of FAR was pointed out by the Tribunal in 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.
FAR was the subject matter of discussion in Wrigley India (P.) Ltd. V. Addl. CIT , 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. This case is a bad example of application of half-hearted FAR analysis.
The importance of FAR can be summarised in the following points:
- Critical to have robust annual TP documentation with in depth FAR analysis and sound economic analysis (including adjustments);
- Comparability strictly based on FAR- intangibles, risks play important role;
- Adjustments to comparables necessary to account for differences in FAR;
- Carefully analyse service operations in India – identify High Value/ IP generating services;
- Evaluate marketing activities and business restructuring in detail;
- PE attribution – focus on FAR analysis and attribution of profits using TP principles by way of upfront analysis; and
- Upfront documentation of a comprehensive FAR analysis followed by a sound economic/ comparability analysis -key to mitigation of risks, passes the onus on Revenue authorities.
(CA Deepanshu Bansal, Partner | Transfer Pricing, Legal Quotient Consultants, Email: email@example.com, Ph: +91-9873681488)