Role of Working Capital Adjustments in Transfer Pricing

Transfer pricing provisions was incorporated in the Income Tax Act in April 2001 and now it has travel the journey of almost two decades in India.

If we give one line principal to the transfer pricing provisions then it is benchmarking of international transactions entered with associated enterprises with comparables transactions (internal or external comparables) for determining arm length price. In benchmarking analysis, selections of the suitable comparables with no material differences is one of the crucial activity.

Income tax provisions allows some adjustments in comparable if reasonable and accurate adjustments can be made.

As per Rule 10B(3) of the Income Tax Rules, an uncontrolled transaction shall be comparable to an international transaction if—

(i)		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
(ii)		reasonably accurate adjustments can be made to eliminate the material effects of such differences.

Accordingly, if difference between international transaction and comparable transactions are material and reasonable adjustment can be made to eliminate the material effects of such difference then said comparable should be selected subject to adjustments to eliminate material effect of such difference.

In a competitive business environment, money has a time value money. Making a working capital adjustment is nothing but an attempt to adjust for the differences in time value of money between the tested party and potential comparables with an assumptions that the difference should be reflected in profits. The reasoning is that:

1. A company will need funding to cover the time gap between the time it invests money (i.e payment to suppliers) & time to collects investments (collection of money from customers)
2. This time gap is calculated as: the period required to sell the inventories to customers plus time required for collection money from customers less period allowed by vendor for payments.

Therefore working capital adjustments is one of main comparability adjustments which play an important role in the elimination of differences in working capital structure of tested party and selected comparables. 

OECD & UN Transfer pricing guidelines allows comparability adjustments if it is possible to make reasonable adjustments to eliminate differences if any. 

United Nation Practice Manual on Transfer Pricing for developing Countries 2021 also provides for adjustment comparables in certain situations.

3.5.3.1 Certain adjustments may be needed in order to satisfy the requirements for accuracy and reliability of the comparables so that the financial results of the comparables are stated on the same basis as those of the tested party. However, the following important issues should be considered before such a comparability adjustment is made:

• Quality of data being adjusted: a comparability adjustment may be made only where it improves the reliability of comparables. If the search process for comparables has major shortcomings, the addition of unreliable or multiple adjustments will not produce reliable arm’s length outcomes;
• Purpose of adjustment performed: adjustments should not be made for differences that have no material effect on prices or margins being tested;
• Not every transaction being compared is capable of being adjusted: there are transactions where reasonably accurate adjustments can be quantified and be made, but in other situations, the accuracy of an adjustment is uncertain and speculative and the adjustment therefore should not be made; and
• Reliability and accuracy of the adjustment: the adjustment should be calculated based on objective and verifiable data.

3.5.3.3 Comparability adjustments can be divided into three broad categories:

1. Accounting adjustments;

2. Balance sheet/working capital adjustments; and

3. Other adjustments.

3.5.3.8 It is very common for the tested party and each of the potential comparables to differ materially in the amount of working capital (inventory, accounts receivable and payable). Such differences are generally caused by differences in the financing terms of purchases and sales that the company receives from its suppliers and extends to its customers, and by differences in the levels of inventory held by the company. Such differences may generate substantial differences in the working capital structure and may have an impact on the operating profits of the companies due to the financing costs. In order to reduce the effect of differences in terms of purchases and sales and levels of inventory on profitability, adjustments can be made to reflect the time value of the receivables, payables and inventory of the comparables. This, however, should be done only if such adjustments can be reasonably made and they improve comparability.  

3.5.3.9 Adjustments for inventory, accounts receivable and accounts payable follow the same basic mechanics. First a value is calculated as the difference between the ratio of the balance sheet item in question to net sales for the comparables and the same ratio for the tested party. The denominator of these fractions will be an arm’s length amount for the tested party, for example the denominator of a Profit Level Indicator (PLI) can be used. An alternative approach would be to calculate these ratios with respect to operating expenses such as where gross profit/operating expenses are the PLI used. The resulting difference in the ratios is then multiplied by an interest rate and by the net sales of the comparables to generate an amount to adjust the income statements of the comparables. Then the PLI of that comparable is recomputed.

OECD Transfer Pricing Guidelines for Multinational Enterprises & Tax Administrations also provides for comparability adjustments. As per guideline comparable means that none of differences (if any) between the situation being compared could materially affect the conditions being examined in the methodology or that reasonable adjustment can be made to eliminate the effect of any such differences.

A.6.1 Different types of comparability adjustments

3.48 Example of comparability adjustment includes adjustments for accountings consistency designated to eliminate differences that may arise from accounting practices between the controlled and uncontrolled transactions, segmentation of financial data to eliminate significant non-comparable transactions; adjustments for differences in capital, functions, assets, risks.

3.49 An example of working capital adjustment designed to reflect different level of account receivables, account payable and inventory is provided in the Annex to Chapter-III. The fact that such adjustment are found in practice does not mean that they should be performed on a routine or mandatory basis.

Process of calculating working capital adjustments as per OECD guidelines is given below:

Step-1: Identify differences in the level of working capital. Normally, trade receivables, inventory and trade payable are considered for calculating working capital adjustment as information of these is easily available from financial statements.

In TNM Method is applied relative to an appropriate base ex: cost, sales or assets. If the base is cost, then any differences in working capital level should be measured relatives to cost.

Step-2: Calculate a value for differences in levels of working capital between tested party and comparable relative to appropriate base and reflecting time value of money by use of an appropriate interest rate.

Step-3:  Adjust the results to reflect differences in level of working capital.

An illustration is provided to demonstrate working of working capital adjustment:

Particulars	Tested Party	Comparable Party
Sales  (A)	1000	1300
Operating profit (B)	50	80
Operating profit margin (PLI) (C)- B/A	5%	6.15%
Net working capital
Average account receivables* (D)	500	700
Inventory  (E)	90	110
Average account payable* (F)	60	60
Net working capital (G)- (D+E-F)	530	750
% of Working capital to sale G/A	53%	57.70%
Difference in working capital structure of tested party and comparable (H)		-4.70%
Interest rate on working capital (I)		14%
Adjustment (J)- (I*H)		-0.658
PLI after adjustment for the comparables	5%	-5.492 (6.15-0.658)

* Opening and closing balance average

It is universal facts that in the arena of transfer pricing, both UN and OECD transfer pricing guidelines are treated as guiding factor and have a strong persuasive value throughout the world. Both Transfer pricing guidelines supports working capital adjustments in comparables to eliminate material differences if reliable adjustment is possible considering the facts of case.

Legal Jurisprudence in India: In recent years in plethora of judgements, working capital adjustments is accepted by various judicial authority as a comparability adjustments to eliminate working capital differences in the comparable & tested party.

In most of the cases, transfer pricing officers normally not accepting the working capital adjustment by giving various reasons.  Some important case laws on the issue working capital adjustment are summarized below:

• OECD Guidelines of computation should be followed-In the case of Vodafone India Services (P) Ltd vs Dy. CIT 7140/Mum/2012 that working capital adjustment is appropriate to improve the comparability and while making the working capital adjustment guidelines framed by OECD must be followed.
• Claim of working capital adjustment in TP study is not necessary – In the case of Capgemini India Pvt. Ltd. 2013 33 taxmann.com 5 (Mum), ITAT held that working capital adjustment are required as these do impact the profitability of the companies. A company with substantial working capital cannot be compared with one which has low level of working capital. The average of opening & closing level of working capital can be compared for the purpose of making adjustment. Working capital cannot denied to the assessee simply because it did not claim such adjustment in its TP study. Working capital adjustment improves the comparability.
  
• Artificial limitation of working capital by AO- In the case of Citrix R&D India Pvt Ltd vs DCIT 2016 68 taxmann.com 43 (Bang), contention of assessee  was that working capital adjustment though computed by the TPO at 3.26% was unjustly restricted to 1.71%. ITAT held that the AO cannot force an artificial limitation to the actual working capital ration derived from the comparable companies considered for arm length pricing in TP study.
  
• Negative working capital adjustment by AO- In the case of Apdaptec (India) Pvt Ltd vs CIT 2015 57 taxmann.com 307 (Hyd), ITAT held that when business is carried on without working capital risk by the assessee and when the comparable companies have such risk working capital adjustments, if at all, has to be made only on a positive adjustment and has to be made to the comparables so that they have brought on par with the assessee. The tribunal therefore held that the negative working capital adjustment to the arithmetic mean margin on comparables should not be made.
  
• Assessee failed to demonstrate impact of working capital on profit-In the case of EIT Services India Pvt. Ltd. Vs JCIT (ITAT Bangalore) 2021 , TPO denied working capital adjustment on ground that assessee failed to demonstrate such differences could have any impact on assessee’s profit.  ITAT by relying upon on Rule 10B and OECD transfer pricing guidelines direct TPO/AO to grant working capital adjustment.
  
• TPO rejected working capital adjustment due to service industry – In the case of ACIT vs. Comverse Kenan India Pvt Ltd, the ITAT held that the benefit of working capital adjustment has to be given to the assessee since the assessee has filed a detailed working capital adjustment working and same cannot be dismissed on the ground that the assessee is in the service sector industry.
  
• Whether Average of day to day working capital adjustment to be computed- In the case of Tata McGraw Hill Education (P) Ltd vs ACIT 2015 63 taxmann.com 167, it was held that it is the average working capital deployment which is to be considered, which can be computed with reference to opening & closing working capital deployed and rejected approach based on average day to day working capital.
• In the case of Navisite India (P) Ltd v ITO 2013 37 CCH 110 Delhi held that the components of working capital deployed should be considered on annual basis with the average of opening & closing. 
• No adjustment of receivable if working capital adjustment is taken care of. ITAT Delhi in the case of Kusum Healthcare Pvt Ltd vs. ACIT 6814/Del/2014 held that the working capital adjustment takes into account impact of outstanding receivables and no further adjustment is required if the working capital adjusted margin of the assessee is more than comparable.
• Working capital adjustment cannot be denied citing non-availability without exercising power u/s 133(6)- In the case of Goldman Sachs Services Pvt Ltd [TS-109-ITAT-2020(Bang)-TP] TPO/AO denied working capital adjustments on the ground that public information not available in the public domain. ITAT held that one has to rely on information available in the public domain however revenue has sufficient power u/s 133(6) to demand for information about comparables and non-exercise of such powers is no defense to deny working capital adjustments in absence of sufficient details.
  
• High working capital adjustment allowed- In the case of Torry Harris Business Solutions Pvt Ltd TS ITAT 463 ITAT 2017, ITAT held that once working capital adjustment is made, there is no reason to exclude any company for this reason that working capital adjustment is high if it found that the company is not required to be excluded for any other reason. Working capital adjustment should be made on actual basis.

Conclusion

In transfer pricing analysis there is always an element of estimation because it is not exact science. One has to see that reasonable adjustment is being made so as to both comparable and tested party are on same footing.

It is quite clear that income tax provision, OECD & UN Transfer pricing model permits working capital adjustment to eliminate the differences of working capital structure if any between tested party and comparables. Further, there are numerous judgements also in favor of allowability of working capital adjustment.

Therefore, we need to explore the possibility of working capital adjustment, wherever is required, for the improvement in quality of comparables by eliminate difference of working capital structure.