Transfer Pricing: Comparability Analysis and Functional Analysis

1. Introduction: The arm’s length principle in transfer pricing relies on establishing comparability between controlled and uncontrolled transactions. The UN TP Manual 2021 emphasizes the pivotal role of comparability analysis in applying transfer pricing theory to practice.

2. Comparability Analysis Definition (OECD): Comparability analysis, as per the OECD, involves comparing a controlled transaction with an uncontrolled one. Transactions are deemed comparable when differences between them would not materially affect the examined factor (e.g., price or margin), or if accurate adjustments can eliminate such effects.

3. Two Levels of Analysis: Determining the arm’s length price (ALP) requires a two-fold analysis:

• Transactional Level: Analyzing controlled and uncontrolled transactions. 
• Entity Level: Analyzing the tested party and uncontrolled enterprise. 

4. Key Aspects of Comparability Analysis:

• Identifying Commercial/Financial Relations: Accurately delineating the controlled transaction by identifying commercial or financial relations between associated enterprises (AEs). 
• Comparing Conditions: Comparing the conditions and economically relevant circumstances of the controlled transaction with those of comparable transactions between independent enterprises. 

Example: Suppose Company A, an associated enterprise, sells a product to Company B, another associated enterprise. Comparability analysis involves identifying the nature of their relationship and comparing the transaction conditions with those of similar transactions between independent enterprises, ultimately determining the arm’s length price for the product 

Legislative Framework for Comparability Analysis in Indian Transfer Pricing 

1. Recognition of Comparability Analysis: Indian transfer pricing regulations formally recognize the importance of comparability analysis in determining the arm’s length price (ALP) for controlled transactions. Rule 10B(2) outlines specific factors to assess comparability between international or specified domestic transactions and uncontrolled transactions.

2. Key Factors for Comparability (Rule 10B(2)): a) Specific Characteristics: Considering the unique attributes of the property transferred or services provided in both transactions. b) Functions Performed: Evaluating the functions performed, including assets employed and risks assumed by the involved parties. c) Contractual Terms: Analyzing the explicit or implicit contractual terms that dictate the division of responsibilities, risks, and benefits between the parties. d) Market Conditions: Examining the prevailing conditions in the markets where the parties operate, including geographical location, market size, laws, government orders, labor and capital costs, economic development, and competition levels.

3. Critical Role in Method Selection: Rule 10B(2) plays a crucial role in determining the comparability of controlled and uncontrolled transactions, influencing the selection of the ‘most appropriate method’ (MAM) for calculating the ALP. The nature of the controlled transaction and the chosen method impact the degree to which these factors influence comparability.

4. Examination for Both Transactions: Comparability analysis involves assessing the specified factors for both controlled and uncontrolled transactions or entities. The degree of influence of these factors varies depending on the method adopted for determining the ALP under Section 92C.

5. Sensitivity of Methods: While all methods under Section 92C are sensitive to differences between controlled and uncontrolled transactions, the tolerance and acceptability levels differ among methods. A careful analysis of the factors affecting comparability is necessary before accepting or rejecting an uncontrolled comparable under the chosen MAM.

Characteristics of Property or Services in Comparability Analysis 

1. Importance of Characteristics:

• Significance: The nature or characteristics of property (tangible or intangible) or services are crucial factors determining comparability between controlled and uncontrolled transactions. 
• Value Determinants: Differences in specific characteristics often contribute to variations in market values. 

2. CUP Method Sensitivity:

• CUP Method Relevance: Particularly crucial in methods like the Comparable Uncontrolled Price (CUP), where similarity in characteristics is paramount for effective comparison. 
• Market Value Influence: Products with superior quality and additional features may command higher prices in the market. 

3. Example Illustration:

• Quality and Features Influence Price: A product with superior quality and more features may have a higher market value compared to an inferior product with fewer features. 
• Non-Comparable Prices: Without adjustments, prices of these two products would not be considered comparable. 

4. OECD Guidelines:

Considered Characteristics: 

• Tangible Property: Physical features, quality, reliability, end-use, etc. 
• Services: Nature and extent of services provided. 
• Intangible Property: Form of transaction, type of property (e.g., patent, trademark), duration and degree of protection, anticipated benefits. 

5. Indian Legislative Recognition:

• Alignment with OECD Guidelines: Indian transfer pricing regulations recognize the relevance of these factors in conducting a comparability analysis. 
• Holistic Consideration: Both tangible and intangible property, along with services, are acknowledged in the legislative framework. 

6. Adjustments for Comparability:

• Necessity for Adjustments: Differences in characteristics may require adjustments to make prices comparable. 
• Parity Through Adjustments: Adjustments ensure that products with varying characteristics are brought to par for effective comparison. 

Effect of Characteristics on Most Appropriate Method (MAM) 

The characteristics of property or services significantly impact the selection of the Most Appropriate Method (MAM) in transfer pricing analysis. A classification of methods under section 92C of the Income Tax Act provides insights into how these characteristics influence the choice of the MAM: 

(a) Price Based Method – Comparable Uncontrolled Price (CUP): 

• • Importance of Characteristics: Crucial due to the one-to-one comparison in CUP. 
  • Stringency in Comparability: CUP method demands the strictest level of similarity in characteristics. 
  • Adjustment Necessity: Material differences in property characteristics may require adjustments for an accurate benchmark. 
  • OECD Support: OECD guidelines affirm the strict comparability requirement for CUP. 

(b) Gross Profit Based Methods – Cost Plus and Resale Price: 

• • Focus on Profit Margins: Comparison of gross profit margins is the basis for these methods. 
  • Impact of Characteristics: Differences in property or service characteristics are less likely to affect gross profit margins. 
  • OECD Confirmation: Resale price and cost plus methods are less sensitive to such differences. 

(c) Net (Operating) Profit Based Methods – Transactional Net Margin Method (TNMM): 

• • Condition for Arm’s Length: Comparison of net profit margins for controlled and uncontrolled transactions. 
  • Liberal Comparability: Characteristics’ influence is more liberal under TNMM. 
  • Consideration of Industry Norms: Tolerance for differences due to reflections in operating expenses, but they need to belong to the same genus. 

(d) Others – Unique Intangibles, Complex Transactions: 

• • Specialized Transactions: Controlled transactions involving unique intangibles or complex inter-related transactions may pose challenges. 
  • Challenges in Application: Price or profit-based methods may be ineffective. 
  • Solution – Profit Split Method (PSM): Allocates profits based on relative contributions, considering functions, assets, and risks. 

Functions, Assets, and Risks Analysis (FAR) in Transfer Pricing 

1. Definition and Significance:

• Definition: Functional Analysis, or Functions, Assets, and Risks (FAR) analysis, is crucial in identifying economically significant activities, responsibilities, assets used, and risks assumed by parties in a transaction. 
• Significance: Compensation or pricing in a transaction is a result of these functions, assets, and risks. FAR analysis helps delineate controlled transactions, select tested parties, and determine comparability. 

2. Focus of Analysis:

• Independent Transactions: In independent business transactions, compensation reflects the functions performed, assets used, and risks assumed. 
• Search for Comparables: FAR analysis guides the search for comparables with a similar allocation of functions, assets, and risks. 

3. Role in Transfer Pricing:

• Selection of Tested Party: Functional analysis aids in selecting the tested party or parties. 
• Method and Comparables Selection: It helps in determining the most appropriate transfer pricing method and selecting comparables. 
• Profit Appropriateness: FAR analysis assesses whether profits or losses align with functions, assets, and risks. 

4. Components of FAR Analysis:

Functions Performed: 

• Definition: Activities carried out by each party in the transaction, focusing on economically significant functions. 
• Critical Functions: Identification of critical functions is more important than the number of functions. 
• Examples: R&D, manufacturing, marketing, financial transactions, and various services. 
• Comparability Determination: Functions performed in controlled transactions are compared with those in uncontrolled transactions to assess comparability. 
• Case Example: Entities engaged in high-end functions like analytics or knowledge processing outsourcing services (KPO) cannot be compared with those performing low-end functions like call centers. 

5. Assets Employed:

i. Identification and Nature: 

• • Identification of tangible and intangible assets utilized in the controlled transaction. 
  • Study of departmental roles in performing functions and using assets. 

ii. Detailed Study: 

• • Identification of asset types (age, market value, location, rights) and quantitative assessment where possible. 
  • Understanding the development, ownership, and benefit aspects of intangibles. 

Example: In a technology transfer transaction, understanding the rights, ownership, and development responsibilities of the involved entities.

6. Risks Assumed:

i. Nature and Identification: 

• • Understanding and identification of risks undertaken by each party in the transaction. 
  • Acknowledgment of the relationship between risks and expected returns in the open market. 

ii. Common Risks: 

• • Market risk, technology risk, product/service liability risk, credit risk, foreign exchange risk, manpower risk, and capacity utilization risk. 

iii. Risk Analysis Steps (OECD Six-Step Process): 

• • Step 1: Identification of economically significant risks. 
  • Step 2: Contractual assumption of risk. 
  • Step 3: Functional analysis concerning risk. 
  • Step 4: Interpretation of Steps 1-3. 

Contractual compliance check. 

Evaluation of the party assuming the risk in terms of control and financial capacity. 

• • Step 5: Allocation of risk. 
  • Step 6: Pricing of the transaction, considering the consequences of risk allocation. 

iv. Importance of Risk Analysis: 

a. Risk-Return Relationship: Recognition that risk and return are correlated; higher risks generally associate with higher expected returns.

b. Adjustment Facilitation: Facilitates adjustments based on risk variations between controlled and uncontrolled transactions.

c. BEPS Actions 8-10 Recommendation: OECD suggests a structured six-step process for analyzing risks in controlled transactions. 

7. Effect of Functional Analysis (FAR) on MAM: 

i. Price-Based Methods (CUP): 

a. Significance: 

• • • Characteristics of property or services are crucial; CUP method requires similarity in characteristics. 
    • Characteristics of property transferred become crucial, requiring strict comparability. 

ii. FAR Influence: 

• • Material variations in characteristics necessitate adjustments. 
  • OECD guidelines emphasize the strictness in comparability for CUP method. 

8. Gross Profit-Based Methods (RPM, CPM): 

a. Focus: Gross profit margins compared; similarity in functions, assets, and risks is more critical. 

b. FAR Importance: 

• • Differences in characteristics have a lesser impact on gross profit margins. 
  • OECD guidelines state that some differences in characteristics are less likely to affect gross profit margins. 

9. Net Profit-Based Methods (TNMM): 

i. Desirability of FAR Similarity: 

• • Broad similarity in FAR desirable; net profit margins derived from all operating business functions. 
  • FAR analysis crucial for profit-based methods like TNMM. 

10. Profit Split Method (PSM): 

i. FAR Significance: 

• • Allocation of combined profits based on relative contribution measured in terms of functions, assets, and risks. 
  • FAR analysis critical for effective application of PSM. 

11. Effect of Contractual Terms on MAM: 

i. Price-Based Methods (CUP): 

a. Contractual Impact: 

• • • Bigger impact in price-based methods compared to profit-based methods. 
    • Credit terms, volume discounts, and shipment terms crucial for CUP method. 

b. Considerations: Similarity in contractual terms is crucial in determining comparability. 

12. Profit-Based Methods (TNMM): 

i. Contractual Terms Importance: 

• • Less crucial in profit-based methods; net profitability compared at entity level. 
  • Effect of differences in contractual terms may be evened out when comparing net profitability. 

13. Priority Consideration: 

i. When Contractual Terms Unavailable: 

• • Profit-based methods prioritized if contractual terms of potential comparables are not available or have a significant impact. 
  • Economic analysis and adjustments required for significant impact of contractual terms on functions and risks. 

14. Market Conditions in Transfer Pricing 

i. Market Conditions Impacting Transactions:

a. Isolation and Business Transactions: No business operates in isolation; transactions influenced by internal and external factors. 

ii. Internal and External Environment: 

a. Internal Conditions: 

• • • Within the enterprise’s control. 
    • Includes business policies, plans, production methods. 

b. External Conditions: 

• • • Beyond the enterprise’s control. 
    • Encompasses all conditions over which the enterprise has little control. 

15. Rule 10B(2) Requirements:

i. Conditions for Consideration: 

• • Rule 10B(2) specifies conditions to be considered, including: 

(a) Geographical location 

(b) Size of markets and competition level 

(c) Laws and government orders 

(d) Costs of labor and capital 

(e) Overall economic development 

(f) Competition nature (retail or wholesale) 

16. Specific Conditions for Consideration:

i. Geographical Location: 

• • Importance of comparable geographical locations in benchmarking exercises. 
  • Differences in markets may result in varied transaction prices. 

ii. Size of Markets and Competition: 

• • Consideration of market size and competition level. 
  • Influences pricing strategies and competitiveness. 

iii. Laws and Government Orders: 

• • Legal and regulatory environment impact transactions. 
  • Compliance with laws and government orders essential. 

iv. Costs of Labor and Capital: 

• • Analysis of labor and capital costs in the relevant markets. 
  • Influence on pricing decisions and profit margins. 

v. Overall Economic Development: 

• • Evaluation of economic development in the market. 
  • Economic conditions affect pricing dynamics. 

vi. Level of Competition (Retail or Wholesale): 

• • Nature of competition, whether retail or wholesale, affects pricing structures. 

17. Compliance with Rule 10B(2):

i. Mandatory Considerations: 

• • Rule 10B(2) mandates consideration of specified conditions. 
  • Essential for accurate transfer pricing analysis. 

A) Geographical Location and Transfer Pricing

18. Importance of Geographical Location:

i. Benchmarking Exercise: 

• • Effective benchmarking requires comparable geographical locations for accurate analysis. 
  • Identical products may have different prices in different markets. 

ii. Consideration of Uncontrolled Comparables: 

• • If information from the same market is unavailable, uncontrolled comparables from a different geographic market may be considered. 
  • Conditions must be similar, or adjustments made for relevant differences. 

19. Concept of Location Savings:

• Definition: Location savings: Net cost savings realized by a multinational enterprise (MNE) due to relocating operations from a high-cost to a low-cost jurisdiction. 

• Transfer Pricing Relevance: Raises questions on how location savings should be shared among parties involved in the transaction. 

• OECD Guidelines (Paras 9.127 to 9.129): 

• • Response depends on what independent parties would agree upon in similar circumstances. 
  • Considerations include functions, assets, risks, and bargaining powers. 

20. Example Scenario: Enterprise Restructuring:

i. Scenario Details: 

• • Enterprise in Country A relocates manufacturing to Country B for cost savings. 
  • Enterprise in Country A retains brand rights and design functions. 
  • Clothes manufactured by the affiliate in Country B under a contract arrangement. 

ii. Allocation of Location Savings: 

• • Question arises on whether location savings should be attributed to Country A, Country B, or both. 
  • Arm’s length principle dictates determining comparable conditions for a third-party manufacturer. 

21. Judicial Perspectives on Location Savings:

i. Li & Fung Case (Delhi ITAT): 

• • Taxpayer created location savings for its AE. 
  • Benefit of the advantage should be shared by the taxpayer. 

ii. GAP International Case (Delhi ITAT and HC): 

• • No additional allocation for location savings required. 
  • Location savings benefit the industry as a whole, reflected in profitability earned by comparables. 

iii. Watson Pharma Case (Bombay HC): 

• • No adjustment for locational advantage as both assessee and comparables were situated in India. 

iv. Syngenta India Ltd Case (Mumbai Tribunal): 

• • Deleted transfer pricing adjustment on location savings, citing absence of specific provisions in Indian regulations. 

v. UN Manual Submission by Indian Revenue: 

• • Recognizes the effect of location savings, suggests factoring it into the results of local comparable companies. 

B) Market Size and Competition:

i. Impact on Pricing Strategies: 

• • An enterprise’s pricing strategies are influenced by the size of the market it operates in. 
  • Larger market share allows for selling higher volumes, potentially at reduced prices. 

ii. Example Scenario: 

• • If a company has a significant market share, it may not hesitate to sell at reduced prices. 
  • Comparing such transactions with a market where skimming policy is applied may yield inconclusive results. 

iii. Level of Competition: 

• • Highly competitive markets may force entities to lower margins and prices. 
  • Less competitive markets may allow for higher margins and pricing accordingly. 

22. Government Laws and Orders:

i. Impact on Prices and Margins: 

• • Government policies and regulations significantly affect entity prices and margins. 
  • Examples include price controls, interest rate controls, exchange controls, subsidies, and anti-dumping duties. 

ii. Pharmaceutical Formulations Example: 

• • Pricing regulations in certain countries can affect pharmaceutical formulations. 

23. Cost of Labor and Capital:

i. Determinant of Product Price:

• • Product price is computed by adding the desired profit margin to the cost of production. 
  • Variation in labor and capital costs across markets influences transaction prices. 

• • Example Scenario: Cheaper labor costs in certain Asian countries affect the comparability analysis. 

24. Overall Economic Development:

i. Consideration in Comparability Analysis: 

• • The overall economic development level is a factor in comparability analysis. 
  • More developed economies may have larger disposable incomes, influencing market participants to charge higher prices.

• Example Scenario: In developed economies like the USA, higher disposable income may result in higher product/service prices. 

25. Nature of Market – Wholesale or Retail:

i. Effect on Transaction Prices/Margins: 

• • Prices in wholesale markets are generally lower than those in retail markets. 
  • Nature of the market in which an enterprise operates affects transaction prices and margins. 

ii. Consideration in Transfer Pricing: 

• • The wholesale or retail nature of the market is a critical consideration in transfer pricing. 

26. Reasonably Accurate Adjustments (Comparable): 

i. Rule 10B(3) Requirements: 

• • Uncontrolled transactions are considered comparable if no material differences exist. 
  • Material differences warrant reasonably accurate adjustments for a fair comparison. 

ii. Importance and Caution: 

• • Adjustments enhance comparability, but their number, magnitude, and reliability affect the overall analysis. 
  • Consideration of adjustments must be careful and aligned with reliable comparability analysis. 

iii. OECD Guidelines Alignment: 

• • OECD Guidelines state comparability if differences have no material effect or if reasonably accurate adjustments can be made. 

27. Contemporaneous Data: 

i. Rule 10B(4) Requirements: 

• • Data used for comparability analysis should relate to the same financial year as the controlled transaction. 
  • Contemporaneous data means preparation at the time of the transaction or no later than tax return filing. 

ii. Proviso to Rule 10B(4): 

• • Allows the use of data up to two years preceding the financial year if it influences transfer price determination. 
  • Burden on the assessee to demonstrate the relevance of previous year’s data. 

iii. Judicial Interpretations: 

• • Mumbai Tribunal in Exxon Mobil case emphasized the burden on the assessee for using previous year’s data. 
  • Delhi Tribunal clarified that the proviso is an exception and relevant data is contemporaneous with the financial year. 

iv. OECD Guidelines Perspective: 

• • Encourage use of contemporaneous data for consistency in comparability analysis. 
  • Acknowledge potential variations in business cycles and profitability levels. 

v. CBDT Notification (Multiple Year Data): 

• • CBDT’s 2015 rules permit the use of multiple year data in certain cases (RPM, CPM, or TNMM selected as MAM). 
  • Not applicable for CUP, PSM, or Other Method. 
  • Requires consideration of the weighted average of selected years for each comparable. 

vi. Flexibility during Assessment Proceedings: 

• • If current year data becomes available during assessment proceedings, TPO can use it for analysis. 

28. Comparables in Transfer Pricing 

i. Internal Comparables:

a. Definition and Significance: 

• • • Internal comparables involve transactions between one of the parties in the controlled transaction (taxpayer or AE) and an independent third party. 
    • These comparables are considered significant as the FAR analysis is likely similar, given the common entity’s involvement in the two transactions. 

b. Advantages and Scrutiny: 

• • • Internal comparables offer a higher degree of comparability. 
    • However, rigorous scrutiny is necessary, and adjustments should be made where necessary. 

c. Judicial Perspectives:

• • • Delhi Tribunal in the case of Destination of the World (Subcontinent) P. Ltd. emphasized giving preference to internal comparables. Reference to external results is considered only when internal comparables are not feasible. 

Example: If a company, A, provides services to its AE and unrelated parties under similar terms, internal comparables involve analyzing the results of A’s transactions. Adjustments may be made for any differences between the transactions. 

29. External Comparables:

i. Definition and Significance: 

• • External comparables involve transactions between two independent parties, neither of which is part of the controlled transaction. 
  • Generally, the level of comparability in external comparables is perceived as less precise. 

ii. Considerations and Preferences: 

• • External comparables may lack precision, but preferences should be given to them, especially when internal comparables involve slightly different products or terms. 
  • Judicial decisions highlight situations where external comparables are preferred over internal ones. 

iii. Judicial Perspectives: 

• • Mumbai ITAT in the case of Genisys Integrating System (I) P. Ltd. favored internal TNMM over external TNMM when reliable internal data was available. 

Example: If a company, B, offers a variation of its product exclusively to its AE and a slightly different variation to unrelated parties, external comparables involving the identical product are preferred over internal comparables involving a somewhat similar product. 

30. Use of Net Margins as Internal Comparables:

i. Issue and Judicial Ruling: 

• • A question arises whether net margins realized from a transaction with one AE, accepted at arm’s length, can serve as an internal comparable for another AE. 
  • Mumbai ITAT in Technimont ICB Pvt. Ltd. held that the Act and Rules focus on comparing the assessee’s international transactions with comparable ‘uncontrolled transactions,’ excluding transactions between associated enterprises. 

Example: If a company’s net margins from a transaction with AE X are accepted at arm’s length, it may not serve as an internal comparable for a transaction with AE Y due to the exclusion of controlled transactions in determining ALP. 

31. Process for Identification and Selection of External Comparables 

1. Introduction:

i. Internal vs. External Comparables: 

• • Preference is given to internal comparables in determining the Arm’s Length Price (ALP) if available. 
  • In the absence of internal comparables, the focus shifts to external comparables. 
  • Judicial decisions guide the selection process based on publicly available data. 

ii. Major Steps in the Selection Process:

The process for identification and selection of external comparables in transfer pricing involves several steps and considerations. While internal comparables are preferred when available, external comparables are sought through a systematic process. The Indian transfer pricing regulations don’t specify a particular method, but judicial decisions offer guidance on the selection process. 

iii. Selection of Database: 

• • Databases like Capitaline Plus, Prowess, and ACE TP are commonly used for maintaining financial and non-financial information about companies. 
  • Publicly available data is usually preferred, and taxpayers have the right to challenge information used against them. 

iv. Application of Quantitative Filters: 

• • Various quantitative filters are applied to reduce the pool of potential comparables. 
  • Filters include turnover, net worth, export turnover, employee expense ratio, and related party transactions. 
  • Turnover filter is crucial to ensure comparability in market share and profitability. 
  • Negative net worth and consistently loss-making companies are often excluded. 

v. Application of Qualitative Filters: 

• • Further refinement is done through qualitative filters. 
  • Product filter ensures comparability in the type of products traded or manufactured. 
  • Functional filter ensures alignment in the functions performed by companies. 
  • Ownership (government or private) filter considers the profit motive and societal service orientation. 

vi. Examples of Judicial Decisions: 

• • Courts have supported the inclusion of government-owned companies based on their comparability. 
  • The judiciary emphasizes factual assessments in determining comparability, considering factors like functions, industry, and profit motive. 

vii. Contemporaneous Data: 

• • Data used for comparability analysis should be contemporaneous, prepared at the time of the transaction or no later than filing the tax return. 
  • The use of multiple-year data is encouraged if it adds value to the analysis, with specific rules for different transfer pricing methods. 

viii. Overall Considerations: 

• • Market size, competition, government regulations, labor and capital costs, economic development, and market nature (wholesale or retail) impact pricing strategies. 
  • Adjustments for material differences between controlled and uncontrolled transactions are crucial for accurate comparability analysis. 

2. Work done by International Organisations:

International organizations, including the IMF, OECD, UN, and World Bank, collaborate through the Platform for Collaboration on Tax (PCT) to provide toolkits and guidance for effective transfer pricing documentation. These efforts aim to assist countries, particularly developing ones, in implementing robust transfer pricing regimes. Several key publications highlight their commitment to addressing challenges and providing practical insights: 

3. Toolkit for Addressing Difficulties in Accessing Comparables’ Data: 

• Designed to aid developing countries in implementing transfer pricing regimes. 
• Focuses on overcoming challenges related to accessing data on comparables, crucial for applying the arm’s length principle. 
• Developed by PCT in response to a mandate from the G20’s Development Working Group. 

4. Guidance on the Transfer Pricing Implications of the COVID-19 Pandemic: 

• Clarifies and illustrates the application of the arm’s length principle to address challenges posed by the COVID-19 pandemic. 
• Developed and approved by the 137 members of the OECD/G20 Inclusive Framework on BEPS. 

5. Practical Toolkit for Transfer Pricing Documentation in Developing Countries: 

• Compiles essential information on transfer pricing documentation. 
• Analyzes policy choices and legislative options, offering sample legislation, real-life examples, and practices from over 30 countries. 

6. Transfer Pricing Country Profiles: 

• Focuses on domestic legislation regarding key transfer pricing principles in different countries. 
• Covers arm’s length principle, transfer pricing methods, comparability analysis, intangible property, and more. 

Economic Analysis and Selection of Tested Party: 

Process Overview:

Following the functional analysis of controlled transactions, the economic analysis involves selecting the tested party and applying the Most Appropriate Method (MAM) to determine the arm’s length price. 

1. Selection of Tested Party: 

Before searching for comparable data, identification of the tested party is crucial. The tested party is the reference point for which comparable data is sought and the MAM is applied. Key considerations in selecting the tested party include consistency with the functional analysis undertaken. 

2. Dispute Over Tested Party: 

The concept of the tested party has been a contentious issue in India’s transfer pricing legislation due to its non-recognition. In contrast, the 2022 OECD Guidelines and the UN TP Manual (2021) endorse this concept, emphasizing the importance of choosing the appropriate tested party. According to the OECD, the tested party should be the one to which a transfer pricing method can be applied most reliably, considering the complexity of functional analysis. 

3. Criteria for Tested Party Selection: 

Common attributes across various guidelines: 

• The tested party should have reliable and accurate data available. 
• It should be the least complex among the parties to the transaction. 
• Data of the tested party should require the least adjustments for comparability. 

4. OECD and US Treasury Regulations: 

The OECD guidelines emphasize choosing the party with less complex functional analysis. Similarly, US Treasury Regulations state that the tested party is the one with verifiable profits and the least complexity, especially concerning risks and valuable intangibles. 

5. UN TP Manual: 

The UN TP Manual underscores consistency with functional analysis and attributes of controlled transactions. The tested party is typically the less complex party with the most reliable data for comparison. 

Tested Party Selection in Indian Context: The Indian transfer pricing regulations do not explicitly recognize the concept of the tested party, but it is imperative to choose one for benchmarking controlled transactions. The absence of direct recognition does not negate the necessity of selecting a tested party. 

Example:

Consider ABC Ltd, an Indian subsidiary of ABC Inc., USA, engaged in manufacturing skin care products. ABC Ltd, being a low-risk, less complex manufacturer with no unique intangibles, is akin to a contract manufacturer. In this scenario, ABC Ltd, India can be considered as the tested party, showcasing the practical application of the concept. 

Judicial Decisions Involving Selection of the Tested Party: 

(a) Can a Foreign AE be Chosen as the Tested Party? 

The selection of the tested party in transfer pricing assessments often involves the question of whether a foreign Associated Enterprise (AE) can be considered. This has been a topic of debate and has led to diverse judicial decisions. 

1. Ranbaxy Laboratories Ltd. Case: In this case, the Tribunal held that the tested party should ideally be the one for which reliable data is readily available, and minimal adjustments are needed. While there is a preference for the least complex entity, the critical factor is the availability of reliable data. The Tribunal emphasized that if a taxpayer chooses a foreign AE as the tested party, it must ensure relevant data is accessible, either in the public domain or furnished to tax administration. 

2. General Motors India Pvt. Ltd. Case: The Ahmedabad Tribunal supported the notion that a foreign entity could serve as a tested party, aligning with the UN Transfer Pricing Manual. It dismissed the argument that tax authorities lacked jurisdiction over foreign entities, emphasizing the tax authorities’ technological capabilities to gather global information. The Delhi Tribunal also endorsed the selection of a foreign party if reliable data is easily available. 

3. Onward Technologies Case: In contrast, the Mumbai Tribunal rejected the idea of substituting the profit earned by a foreign AE with that of comparables. It emphasized that the scope of TP adjustment under Indian taxation law is limited to the transaction between the assessee and its foreign AE, making the profit substitution unacceptable. 

4. GlobalVantedge Case: The Delhi Tribunal, echoing the preference for the least complex party, held that a foreign entity should not be chosen due to difficulties in comparing entities in different jurisdictions. 

5. Bekaert Industries and Carraro India Case: The Pune Tribunal emphasized that considering a foreign AE as the tested party renders relevant sections of the law redundant and is an unacceptable proposition. 

6. Almatis Alumina Case: The Calcutta High Court upheld the ITAT’s order, affirming that a foreign AE can be considered as the tested party. It highlighted that the tested party should be the least complex, and there is no restriction on selecting a local or foreign party. 

(b) Least Complex Party to be Chosen as the Tested Party: 

The selection of the tested party is a critical aspect of transfer pricing analysis, and a common principle is to choose the least complex entity. This principle is evident in various judicial decisions. 

1. Missionpharma Logistics Pvt. Ltd. Case: The Ahmedabad Tribunal highlighted the importance of assessing the complexity of the parties involved. In this case, the assessee company, not involved in developing intangible assets, was considered less complex compared to its AEs. The AEs, bearing risks and owning intangibles, were deemed more complex. The availability and reliability of data further supported choosing the assessee as the tested party. 

2. Development Consultants P. Ltd. Case: The Kolkata Tribunal referred to US Transfer Pricing regulations, emphasizing the necessity of selecting a tested party without valuable intangible property or unique assets. This principle aligns with the global understanding that the least complex entity should be chosen. 

3. GKN Driveline (India) Case: In the GKN Driveline (India) case, Delhi ITAT rejected the consideration of a foreign AE as the tested party for AY 2012-13. The ITAT invoked Para 3.18 of OECD TP Guidelines, stating that the tested party should be the least complex entity with reliable data and minimal adjustments. The assessee’s failure to provide the AE’s FAR details and financials contributed to the rejection. 

The Most Appropriate Method (MAM) in Transfer Pricing: 

Introduction: 

The selection of the Most Appropriate Method (MAM) is a critical step in the benchmarking process for controlled transactions. Indian transfer pricing regulations, under section 92C of the Act and Rule 10B of the Rules, prescribe six methods without specific order or priority, emphasizing the concept of the ‘Most Appropriate Method.’ The MAM is the one that best suits the specific facts and circumstances of each transaction. 

Prescribed Methods: 

The methods specified under section 92C are: 

• CUP Method (Comparable Uncontrolled Price) 
• RPM (Resale Price Method) 
• CPM (Cost Plus Method) 
• PSM (Profit Split Method) 
• TNMM (Transactional Net Margin Method) 
• Any Other Method 

Key Judicial Interpretations: 

In the case of Cargill Foods India Ltd, the Pune Tribunal emphasized that the MAM selected for comparability analysis should be the one most suited to the specific transaction. Section 92C(1) lists five methods, but the chosen method must provide the most reliable measure of an arm’s length price. 

Rule 10C Factors for MAM Selection: 

Rule 10C of the Rules provides factors for MAM selection: 

• Nature and Class of Transactions: Understanding the type of international or specified domestic transactions. 
• Functions, Assets, and Risks of Associated Enterprises: Considering the functions performed, assets employed, and risks assumed by associated enterprises. 
• Data Availability and Reliability: Assessing the availability, coverage, and reliability of data needed for method application. 
• Comparability: Evaluating the degree of comparability between controlled and uncontrolled transactions. 
• Adjustment Feasibility: Examining the extent to which reliable adjustments can be made for differences between transactions. 
• Nature of Assumptions: Considering the nature, extent, and reliability of assumptions required for method application. 

OECD Guidelines Factors for MAM Selection: 

The OECD Guidelines, in alignment with Indian regulations, suggest factors for MAM selection: 

• Appropriateness in View of Controlled Transactions: Considering the method’s appropriateness based on a functional analysis of controlled transactions. 
• Availability of Reliable Information: Evaluating the availability of reliable information, especially on uncontrolled comparables. 
• Degree of Comparability: Assessing the degree of comparability between controlled and uncontrolled transactions, including the reliability of required adjustments. 

Importance of Prescribed Methods: 

The choice of method to benchmark controlled transactions is a pivotal aspect of transfer pricing regulations. Section 92C of the Act, along with Rule 10B, prescribes six methods, and the Mumbai Tribunal, in the case of CA Computer Associates Pvt. Ltd, clarified that the Arm’s Length Price (ALP) must be determined using one of these methods. 

Judicial Decisions and Accepted Practices: 

• CA Computer Associates Pvt. Ltd: The Mumbai Tribunal emphasized that when determining ALP, the prescribed methods in Rule 10B must be applied. Deviating from this mandate is not permissible, as later accepted by the Bombay High Court. 
• L.G. Electronics India Pvt. Ltd.: The Special bench of the Delhi Tribunal highlighted that the legislature specifically mandates the use of prescribed methods. Any other method applied by the Transfer Pricing Officer (TPO) is against this statutory provision. 
• Castrol India Limited: The Tribunal in Castrol India Limited stressed that the TPO should work out the ALP using an authorized method. Disallowing the entire cost without conducting a proper ALP determination is not acceptable. 
• Quintiles Research (India) Private Ltd.: The Bangalore Tribunal, in Quintiles Research, referenced the importance of TPO jurisdiction. It clarified that the TPO cannot arbitrarily determine that no services were rendered, leading to a NIL arm’s length price. 

Examples of Method Selection in Specific Cases: 

• Aithent Technology: In this case, the Delhi Tribunal determined that the Comparable Uncontrolled Price (CUP) method was the most appropriate for assessing the arm’s length price of interest-free loans to associated enterprises. 
• Star Diamond Group: The Tribunal held that the Resale Price Method (RPM) was the most appropriate for a trading entity that did not add value to goods. 
• Bayer Material Sciences: The Mumbai Tribunal established that for indenting activity involving commission income, the CUP method was more appropriate than TNMM. 
• L’oreal India Pvt. Ltd.: The Mumbai Tribunal and Bombay High Court confirmed the Resale Price Method (RPM) as the most appropriate for determining the arm’s length price in the distribution and marketing activities of the goods. 
• GE BE P. Ltd.: For contract manufacturing, the Tribunal held that the Cost Plus Method (CPM) was more suitable than TNMM. 
• Yamaha Motor India Pvt. Ltd.: In a resale transaction without substantial value addition, the Tribunal determined that RPM, not TNMM, was the most appropriate method. 
• Amphenol Interconnect India: Bombay High Court upheld the Tribunal’s decision, confirming that TNMM was the most appropriate for benchmarking exports to associated enterprises. 
• AWB India Private Limited: The Delhi bench of ITAT emphasized the importance of comparables in the CUP method. In the absence of comparables, determining the arm’s length price as NIL is not justified. 

Arithmetical Mean in Case of Multiple ALPs: 

The first proviso to section 92C(2) of the Act addresses scenarios where the application of the Most Appropriate Method (MAM) results in more than one Arm’s Length Price (ALP). In such cases, the legislative provision mandates the use of the arithmetical mean of all determined prices as the deemed ALP for the controlled transaction. This approach seeks to provide a balanced consideration of comparable transactions, considering the inherent variations in business scenarios. 

Tolerance Band and Government Notifications: 

Recognizing the approximative nature of ALP determination, the second proviso to section 92C(2) allows for a tolerance band to accommodate slight deviations. Initially set at 5%, subsequent amendments by the Finance Act 2011 and 2012 refined this range. For FY 2012-13 onwards, the upper limit was fixed at 3%, subject to government notifications specifying the exact percentage. 

Government notifications, such as the one for AY 2019-20, have maintained a tolerance range of 1% for wholesale traders and 3% for other taxpayers. This legislative framework provides a reasonable degree of flexibility, acknowledging the dynamic nature of business environments. 

Illustrative Example: 

For instance, if a taxpayer sells goods to an Associated Enterprise (AE) at Rs. 100, and similar goods are sold to unrelated parties at Rs. 100 and Rs. 110, the arithmetical mean of these prices (Rs. 105) becomes the deemed ALP. The tolerance range, then, ensures that if the deviation between the ALP and the controlled transaction price falls within the specified limit (e.g., +/- 3%), the transaction price is considered at arm’s length. 

Range Concept and CBDT Rules: 

Understanding that transfer pricing isn’t an exact science and often results in a range of prices or margins, the CBDT introduced the range concept through rules published in October 2015. The range concept applies to international transactions and specified domestic transactions entered into after April 1, 2014. 

Rule 10CA outlines the conditions for the range concept to be applicable, including MAM selection (CUP, RPM, CPM, or TNMM) and a minimum of 6 comparables. If these conditions are met, the arm’s length range is determined between the 35th and 65th percentile of the dataset. If the transaction price falls within this range, no adjustments are necessary. However, if it falls outside the range, the ALP is taken as the median of the dataset. 

Conclusion: 

The legislative provisions and subsequent amendments provide a structured approach to handle situations where multiple ALPs are determined and allow for a reasonable tolerance band. The introduction of the range concept further acknowledges the complexities of transfer pricing analysis, providing a nuanced framework for determining the arm’s length price in specific cases. Adopting these methodologies with care, guided by legislative provisions, OECD guidelines, and relevant judicial precedents, ensures a robust economic analysis that aligns with the principles of transfer pricing regulations. It is crucial to document these analyses as mandated by Section 92D of the Act.