Transfer Pricing: Why forex gain or loss should not be considered while computing PLI?

CA Hari Om Jindal[1]
Adv. Surya Jindal[2]

Summary: One of the important issues under transfer pricing is that domestic law precedence are used while deciding cross boarder issues under transfer pricing which is not proper because under domestic law both the entities are residing in India, therefore, chances of tax avoidance or evasion are minimal. In this issue, the Authors have discussed that it is almost settled position from the judicial decisions that foreign exchange gain/loss relating on revenue items, like export and import of trading goods or raw material or services, is considered as revenue and segmental in nature for computing PLI under TP.  However, most of these decisions are based on decisions which were decided under domestic law provisions relating to exemption/deduction under section 10A/80HHC etc.  i.e. non-TP issues. As per Authors, forex gain, or loss is not based on conditions which are made or imposed between the two AEs only. It is normal transaction which have nothing to do with related parties’ transaction. The exchange loss/profit depends on those market forces, which are not in control of taxpayer. To penalise the taxpayer based on government policy does not fit in the scheme of transfer pricing. Where one taxpayer sells goods on credit and other on cash, exchange profits/loss can make huge difference in segmental PLI, if it is considered as operative, even the value of international transactions has same value. Therefore, it will be interesting to see whether Government will make specific provisions under law or judicial authorities will took cognizance of this anomaly or the present position will continue?

1. Back ground

We have written an article “Transfer pricing – Why outstanding receivable should not be benchmarked as separate transaction?”[3]. In this article, we have raised some of the very important issues concerning transfer pricing (‘TP’). One of the important issues was that domestic law precedence are used while deciding cross boarder issues under transfer pricing which is not proper because under domestic law both the entities are residing in India, therefore, chances of tax avoidance or evasion are minimal.

In this issue, we are discussing one of those issues, where domestic law precedence are used under TP. It is almost settled position that foreign exchange gain/loss (EG)  relating on revenue items, like export and import of trading goods or raw material or services, is considered as revenue and segmental in nature for computing PLI under TP. Most of these decisions are based on decisions which were decided under domestic law provisions relating to exemption/deduction under section 10A/80HHC etc.  i.e. non-TP issues, which seems to be doubtful.

2. Exchange gain/losses – Judicial Precedence

One of the earliest case under TP is SAP LABS India (P.) Ltd. vs. Asst. CIT [2010] 8 taxmann.com 207 (Bangalore)/[2010] 6 ITR(T) 81 (Bangalore). In this case, the ITAT held as under:

“42. We considered the issue carefully. The foreign exchange fluctuation gains is nothing but an integral part of the sales proceeds of an assessee carrying on export business. This proposition has been time and again considered in cases arising in the context of section 80HHC. The Courts and Tribunals have held that foreign exchange fluctuation gains form part of the sale proceeds of exporter-assessee. Useful reference may be made to the decisions of Bombay High Court in the case of Shah Bros. v. CIT, [2003] 259 ITR 741; that of Gujarat High Court in the case of CIT v. Amba Impex [2006] 282 ITR 144 and that of Mumbai ITAT Spl. Bench in the case of Asstt. CIT v. Prakash L. Shah [2008] 306 ITR (AT) 1. In all the above cases, the dominant question considered was the year of deduction on the accepted proposition that the foreign exchange fluctuation gains computed by an assessee in a relevant previous year should be treated as part of the operating income and thereby it would contribute to the operating margin of the assessee-company. The foreign exchange fluctuations income cannot be excluded from the computation of the operating margin of the assessee-company. This contention of the assessee is accepted.”

However, most of these decisions pertains to deduction/exemption under section 10A/80HHC etc., therefore, the context and purpose is totally different.

Following the decision in case of SAP LABS (Supra), Delhi ITAT in case of Ameriprise India (P.) Ltd. vs. Asst. CIT [2015] 62 taxmann.com 237 (Delhi – Trib.), observed as under:

“16.2 We find merit in the contention raised on behalf of the assessee about the inclusion of foreign exchange gain/loss in the operating revenue/costs of the assessee as well as that of the comparables. When we advert to the nature of such foreign exchange gain earned by the assessee, it has also been admitted by the ld. DR that the same is in relation to the trading items emanating from the international transactions. When the foreign exchange loss directly results from the trading items, we fail to appreciate as to how such foreign exchange fluctuation loss can be considered as non-operating.

16.3 The Special Bench of the Tribunal in Asstt. CIT v. Prakash L. Shah [2008] 115 ITD 167 (Mum) has held that the gain due to fluctuations in the foreign exchange rate emanating from export is its integral part and cannot be differentiated from the export proceeds simply on the ground that the foreign currency rate has increased subsequent to sale but prior to realization. It went on to add that when goods are exported and invoice is raised in currency of the country where such goods are sold and subsequently when the amount is realized in that foreign currency and then converted into Indian rupees, the entire amount is relatable to the exports. In fact, it is only the translation of invoice value from the foreign currency to the Indian rupees. The Special bench held that the exchange rate gain or loss cannot have a different character from the transaction to which it pertains. The Bench found fallacy in the submission made on behalf of the Revenue that the exchange rate difference should be detached from the exports and be considered as an independent transaction. Eventually, the Special Bench held that such exchange rate fluctuation gain/loss arising from exports cannot be viewed differently from sale proceeds.

16.4 In the context of transfer pricing, the Bangalore Bench of the Tribunal in SAP Labs India (P.) Ltd. v. Asstt. CIT [2011] 44 SOT 156/[2010] 8 taxmann.com 207 has held that foreign exchange fluctuation gain is part of operating profit of the company and should be included in the operating revenue. Similar view has been taken in Trilogy E Business Software India (P.) Ltd. v. Dy. CIT [2011] 12 taxmann.com 464/47 SOT 45 (URO) (Bangalore). The Mumbai Bench of the Tribunal in S. Narendra v. Addl. CIT [2013] 32 taxmann.com 196/57 SOT 32 has also laid down to this extent. In view of the foregoing discussion, we are of the considered opinion that the amount of foreign exchange gain/loss arising out of revenue transactions is required to be considered as an item of operating revenue/cost, both of the assessee as well as comparables. We, therefore, hold that the AO was not justified in considering forex loss as non-operating cost as against the assessee’s claim of operating cost.”

This decision is upheld by Delhi High Court in case of Pr. CIT vs. Ameriprise India (P.) Ltd. [2017] 78 taxmann.com 373 (Delhi), by observing as under:

“4. The ITAT has in the impugned order noted the fact that the foreign exchange gain earned by the Assessee is in relation to the trading items emanating from the international transactions. Since the foreign exchange loss directly resulted from trading items, it could not be considered as a non- operating loss. Further, it is noted by the Dispute Resolution Panel that the service agreement between the Associated Enterprise (AE) and the Assessee stated that for the specified products and services provided by the Assessee, it “shall raise invoices on Ameriprise USA on the basis of a cost plus pricing methodology.” The ITAT was therefore right in holding that the AO was not justified in considering the foreign exchange loss as a non-operating cost.

5. Additionally, it is pointed out by Mr Deepak Chopra, learned counsel for the Assessee, that for the subsequent AYs an Advance Pricing Agreement has been entered into between the Assessee and the Central Board of Direct Taxes under section 92CC of the Act on 22nd January 2016 whereunder the aforementioned ‘cost plus pricing methodology’ has been implicitly accepted. Therefore, in the facts of the present case, the Court is of the view that no substantial question of law arises.”

This decision of Delhi High Court in case of Ameriprise India (Supra) became a landmark precedent for later decisions. Recently, Delhi High Court in case of Pr. CIT vs. Samsung India Electronics (P.) Ltd. [2024] 166 taxmann.com 130 (Delhi), observed as under:

3. That only leaves us to examine the issues which are sought to be canvassed and pertain to foreign exchange gain/loss. Those questions too stand answered against the appellant in light of the judgment rendered in ITA 206/2016 dated 23 March 2016. We take note of the following observations as they appear in that decision:

“3. The question sought to be urged by the Revenue is whether the ITAT was correct in directing the foreign exchange gain/loss to be considered as an item of operating revenue/cost?

4. The ITAT has in the impugned order noted the fact that the foreign exchange gain earned by the Assessee is in relation to the trading items emanating from the international transactions. Since the foreign exchange loss directly resulted from trading items, it could not be considered as a non-operating loss. Further, it is noted by the Dispute Resolution Panel that the service agreement between the Associated Enterprise (AE) and the Assessee stated that for the specified products and services provided by the Assessee, it “shall raise invoices on Ameriprise USA on the basis of a cost plus pricing methodology.” The ITAT was therefore right in holding that the AO was not justified in considering the foreign exchange loss as a non-operating cost.”

Therefore, most of the decisions under TP are based on the precedence relating to deduction/exemption under section 10A/80HHC etc., therefore, the context and purpose is totally different. Section 10A/80HHC etc are relating to exemption/deduction, therefore, liberation interpretation is generally adopted by the judiciary. However, TP provisions pertains to tax avoidance scheme, therefore, the context and purpose is totally different. It is true that in TP analysis, there is always an element of estimation because it is not an exact science, however, one has to see that reasonable adjustment is being made so as to bring both comparable and tested party on same footing. An item of revenue or expense which have no corelation with international transaction, can never be part of profit level indicator (PLI).

3. Exchange gain/losses – OECD TPG 2022

The observation of OCED in para 2.88 of the Transfer Pricing Guidelines 2022 (OECD TPG 2022) reads as follows:

“2.88 Whether foreign exchange gains and losses should be included or excluded from the determination of the net profit indicator raises a number of difficult comparability issues. First, it needs to be considered whether the foreign exchange gains and losses are of a trading nature (e.g. exchange gain or loss on a trade receivable or payable) and whether or not the tested party is responsible for them. Second, any hedging of the foreign currency exposure on the underlying trade receivable or payable also needs to be considered and treated in the same way in determining the net profit. In effect, if a transactional net margin is applied to a transaction in which the foreign exchange risk is borne by the tested party, foreign exchange gains or losses should be consistently accounted for (either in the calculation of the net profit indicator or separately).”

Therefore, as per these guidelines, EG should be treated operative if the following conditions are fulfilled:

> Where the foreign exchange gains and losses are of a trading nature (e.g. exchange gain or loss on a trade receivable or payable)

> Where the tested party is responsible for them.

It also says that any hedging of the foreign currency exposure on the underlying trade receivable or payable also needs to be considered and treated in the same way in determining the net profit. Further, foreign exchange gains or losses should be consistently accounted for (either in the calculation of the net profit indicator or separately). Separately may be relevant in case of CUP Method.

As per OECD TPG, where the foreign exchange gains and losses are of a trading nature (e.g. exchange gain or loss on a trade receivable or payable) and the tested party is responsible for them, then such gain/losses should be consistently accounted for.

However, the authors of this article, do not agree with the OECD TPG preposition, due to the reasons explained in this article.

4. Exchange gain/losses – Safe Harbour Provisions

In India, new transfer pricing rules were introduced in 2002. Since then, the number of cases identified for audit and the transfer pricing adjustments locked up in disputes have increased tremendously. In order to reduce the increasing number of transfer pricing audits and prolonged disputes, the Finance (No.2) Act, 2009 w.r.e.f. 1.4.2009 inserted a new section 92CB to provide that determination of arm’s length price under section 92C or 92CA shall be subject to safe harbour rules. By this amendment, the Government of India had empowered the CBDT to make Safe Harbour Rules (SHR). “Safe harbour” is defined to mean circumstances in which the income-tax authorities shall accept the transfer price declared by the assessee. Based on the expert committee’s finding, the CBDT, on 14.8.2013 released draft safe harbour rules for public comments. After considering comments of various stake holders, on 18.9.2013, the CBDT issued the final safe harbour rules. The safe harbour rules are applicable from assessment year 2013-14.

As per rule 10TA(j) “operating expense” means the costs incurred in the previous year by the assessee in relation to the international transaction during the course of its normal operations including [costs relating to Employee Stock Option Plan or similar stock-based compensation provided for by the associated enterprises of the assessee to the employees of the assessee, reimbursement to associated enterprises of expenses incurred by the associated enterprises on behalf of the assessee, amounts recovered from associated enterprises on account of expenses incurred by the assessee on behalf of those associated enterprises and which relate to normal operations of the assessee and] [bold portion is included w.e.f. 1.04.2017] depreciation and amortisation expenses relating to the assets used by the assessee, but not including the following, namely:

(i) interest expense;

(ii) provision for unascertained liabilities;

(iii) pre-operating expenses;

(iv) loss arising on account of foreign currency fluctuations;

(v) extraordinary expenses;

(vi) loss on transfer of assets or investments;

(vii) expense on account of income tax; and

(viii) other expenses not relating to normal operations of the assessee.

It is also provided that reimbursement to associated enterprises of expenses incurred by the associated enterprises on behalf of the assessee shall be at cost. It is also provided that amounts recovered from associated enterprises on account of expenses incurred by the assessee on behalf of the associated enterprises and which relate to normal operations of the assessee shall be at cost.

Similarly, as per rule 10TA(k), “operating revenue” means the revenue earned by the assessee in the previous year in relation to the international transaction during the course of its normal operations [including costs relating to Employee Stock Option Plan or similar stock-based compensation provided for by the associated enterprises of the assessee to the employees of the assessee] [bold portion is included w.e.f. 1.04.2017] but not including the following, namely:

(i) interest income;

(ii) income arising on account of foreign currency fluctuations;

(iii) income on transfer of assets or investments;

(iv) refunds relating to income tax;

(v)  provisions written back;

(vi) extraordinary incomes; and

(vii) other incomes not relating to normal operations of the assesse.

As per rule 10TA(l), “operating profit margin” in relation to operating expense means the ratio of operating profit, being the operating revenue in excess of operating expense, to the operating expense expressed in terms of percentage. Therefore, as per these rules, loss arising on account of foreign currency fluctuations is not an operating expense.

In the case of Pr. CIT v Ameriprise India (P.) Ltd.(Supra), Delhi HC had held that foreign exchange gains earned by the assessee which is in relation to trading items and emanating from international transactions, direct value derived from it cannot be treated as non-operating losses and gains. Followed again by the same High Court in Pr. CIT v B.C. Management Services (P.) Ltd. [2018] 89 taxmann.com 68 (Delhi).. In this case, the revenue seeks to rely on the Safe Harbour Rules which were notified by the Revenue authority and came into force in 2013. According to High Court, the present assessment period covers AY 2011-12; therefore, the treatment cannot be in accordance with those rules as held in Pr. CIT v Cashedge India (P.) Ltd. (2016) 96 CCH 0493 Del HC : IT Appeal No. 279 of 2016, dated 4.5.2016. The Court made the following observations:

“7. Pr. CIT v. Ameriprise India (P.) Ltd. [IT Appeal No. 206 of 2016, dated 23-3-2016], this Court had held that foreign exchange gains earned by the assessee which is in relation to trading items and emanating from international transactions, direct value derived from it cannot be treated as Non- Operating losses and gains.

8. This Court notices that Revenue seeks to rely on the Safe Harbour Rules which were notified by the Revenue authority and came into force in 2013. In these circumstances, given that the present assessment period covers AY 2011-12, the treatment cannot be in accordance with those rules as held in Cashedge India (P.) Ltd., (supra), decided on 04.05.2016. Consequently, no question of law arises.”

However, even after SHR are in force, there is no change in judicial precedence and  the earlier decisions are followed in a recent decision of Pr. CIT vs. Samsung India Electronics (P.) Ltd. [2024] 166 taxmann.com 130 (Delhi)( discussed supra).

5. Double Whammy for the tax authorities?

Now, it’s a double whammy for the tax authorities. Sometimes, it is seen that where the taxpayer incurred exchange losses, they treat it as non-operative, which is also Revenue’s stand in most of the cases. Therefore, it is accepted by tax authorities. However, where the taxpayer earn exchange gains, they treat it as operative and they also win before appellant authorities even this stand is not accepted by tax authorities. Therefore, it is “Heads I win, tails you lose“, situation for the taxpayer. Though, principle of consistency can be applied by tax authorities, however, this principle is applied rarely.

6. Manner of Segment Computation under TP

As per OECD TPG 2022, the TNM method relies on a comparison of an appropriate net profit indicator (generally called as Profit Level Indicator or PLI) for the controlled transaction with the same net profit indicator in comparable uncontrolled transactions. The ratio of net profit is determined based on an appropriate base (eg, costs, sales, assets). Thus, a transactional net margin method operates in a manner similar to the cost plus and resale price methods. This similarity means that in order to be applied reliably, the transactional net margin method must be applied in a manner consistent with the manner in which the resale price or cost-plus method is applied. This means that the net profit indicator of the taxpayer from the controlled transaction should ideally be established by reference to the net profit indicator that the same taxpayer earns in comparable uncontrolled transactions, ie, by reference to “internal comparables”. Where this is not possible, the net margin that would have been earned in comparable transactions by an independent enterprise (“external comparables”) may serve as a guide. A functional analysis of the controlled and uncontrolled transactions is required to determine whether the transactions are comparable and what adjustments may be necessary to obtain reliable results.

Sub-rule (1) of rule 10B lays down the manner in which the ALP in relation to an international transaction must be computed, for various methods. As per rule 10B(1)(e), the computation under TNM method have to be made in the following manner:

“The net profit margin realised by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base.”

The rule provides four bases for calculation of PLI. These are:

• Net profit margin/Cost
• Net profit margin/Sales
• Net profit margin/Assets employed
• Net profit margin/Any other relevant base

Hence, the taxpayer or department can also use any other relevant base apart from three specific bases. However, the numerator in all cases should be net profit margin. It is also important to note that there should be some positive correlation between the net profit margin and appropriate base. It’s not that denominator can be anything.

This topic is also discussed by the Author of this article, in his book[4], the relevant observations are given below:

“11.4 Segmental PLI – Manner of Computation

Before selecting segmental PLI (as is referred to in this book), some of the important points may be useful to understand this concept:

• As the name of method suggest, “transactional net margin method” calculate net margin of only “international transactions” and not of whole enterprise unless all transactions are with AEs only. The net profit margin realised by the enterprise from an international transaction(s) entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base.
• Therefore, operating, non-operating and extraordinary items are considered from the point view of international transactions only and not from the point of view of enterprise.
• Non-operating income and expenses does not form part of the cost or revenue for calculating PLI even they are of normal and recurring nature. For example, dividend and interest may have received on regular basis but may not be part of operating income.
• Similarly, non-segmental income and expenses, ie, income and expenses other than realting to “international transactions”, does not form part of the cost or revenue for calculating PLI even they are of normal and recurring nature. For example, commission income may be operating income, unless it is aggregated for benchmarking purpose, it will not be part of segmental PLI. See also chapter no. 17 – Single or Multiple Transactions for benchmarking.
• Extraordinary and non-recurring items, even operating in nature, generally does not form part of the cost or revenue for calculating PLI. Even if they are considered as operating then adjustment may be required. For example, heavy expenditure on introduction of new product, etc, even operating in nature but require adjustment as comparables may have not incurred this expenditure in the relevant year. Alternatively, this may not be taken as part of cost. It depends on the facts of the case.
• It is very difficult to say which items are operating and which are extraordinary or non-recurring. It depends on the nature of business and purpose of comparison. Same items may be considered as non-operating in one case and operating in other case.
• Revenue and expenses which does not affect the earning of margin from the relevant segment relating to international transactions of which the comparison has to be made, have to be ignored. These items may be operative or non-operative.

The calculation may be made in the following manner:

a. Segmental Revenue

Total revenue/sale

• Less non-operative revenue/sale (as per nature of business)
• Less non-segmental revenue/sale (as per nature of international transactions)
• Less extraordinary/abnormal revenue/sale (as per frequency and amount of transactions)
• Less revenue/sale relating to other years

Segmental normal revenue/sale (Final figure) (a)

b. Segmental Cost

Total cost

• Less non-operative cost (as per nature of business)
• Less non-segmental cost (as per nature of international transactions)
• Less extraordinary/abnormal cost (as per frequency and amount of transactions) (these items may be ignored, or proper adjustments have to be made)
• Less cost relating to income which does not form part of segmental normal revenue

Segmental normal cost (Final figure) (b)

c. Segmental Margin  (a-b=c)

d. Segmental Margin % c/a% or c/b% (as the case may be)”

Simply, the purpose of computing segmental PLI is to match normal cost and revenue relating to the segment (international transaction only) of which the comparison has to be made. Cost and revenue relating to other period, deferred cost/revenue have to be adjusted. For this purpose, special consideration needs to be paid to:

• Accounting policy
• Treatment of expenses between capital/deferred/revenue expenses
• Expenses relating to segment but abnormal or casual
• Depreciation policy
• Cost relating to exempt income
• Reimbursements, where treated as pass through item of revenue and expenses

There is basic flaw in the policy that whatever is included in the case of taxpayer, same should be included in the case of comparables. The right course is whether the items relates to segmental margin. If yes, it has to be taken in both the cases otherwise ignore it. It is not matching of control transaction with uncontrolled transaction, but it is matching of relevant segmental margin of control and uncontrolled transactions.

Therefore, non-operating, extra ordinary (even operative) and non-segmental (even operative) expenses or income have also to be excluded.

Hence, it is not correct position of law that all operating expenses and income have to be taken for computing PLI. Extra ordinary and non-segmental expenses or income have also to be excluded even they are operating in nature. Some of the examples are given below for better understanding.

Warranty costs – Extraordinary  –  In normal business operations of a manufacturer, etc, warranty cost is generally part of normal operative cost and will form part of operative expenditure. However, in extraordinary and unexpected cases, it may also be treated as non-segmental. In the case of Toyota Kirloskar Motors (P.) Ltd. v ACIT (2012) 34 CCH 0533 BangTrib : [2012] 28 taxmann.com 293 (Bang.), the assessee submitted that when the assessee sells its vehicles to various customers, they have an attached warranty condition. In the event of a faulty design or manufacture, defects may arise which were not originally visualized. It is submitted that in the relevant period, the assessee noticed a defect in the exhaust system of the automobiles manufactured by it. Apprehending that there would be increased expenditure to rectify these defects, the assessee made a special one-time provision of 15.90 crore towards warranty costs. The assessee contended that the same being an unusual expenditure and also non-recurring, it ought not to have been included in the operating costs which was what the TPO did. It was further submitted that in the succeeding years, in the assessee’s own case, the TPO had accepted that warranty provision is not operating expenditure and excluded it from operational costs. The revenue submitted that warranty adjustment is not called for on the ground that it is part of the operating expenditure and integral to the tax payers business. This was rebutted by the assessee stating that the this warranty provision is a special, extra-ordinary, one time provision made in the relevant period and therefore it should be excluded while computing operating margins. The ITAT observed that in normal business operations of the kind the assessee is involved in namely, manufacture and sale of passenger cars, warranty would be attached and will form part of operative expenditure. However, in the instant case, from the facts on record, it is clear that the special warranty provision of Rs 15.90 crore to warranty costs was a special, one time provision made to overcome the defects in the exhaust system of the automobile manufactured by it in the relevant period. In that sense, it is clearly an extra-ordinary expense of a non-recurring nature and in that view of the matter requires to be excluded from operating costs. In view of this factual matrix, it was directed that the one-time special warranty provision, arising out of an extra-ordinary, viz, manufacturing defect in exhaust of passenger vehicle in the relevant period should be considered as non-operating expenditure.

Income from settlement of patent infringement – In the case of Mylan Laboratories Ltd. v Asstt. CIT [2015] 63 taxmann.com 179 (Hyderabad – Trib.), the ITAT, based on later year order in the case of same assessee. held that income from settlement of patent infringement suit credited to Profit & Loss account is non-operative in nature. This issue was considered by the ITAT in the later year in assessee’s own case for AY 2008-09 and held as under:

“We agree with the finding of the Assessing Officer as held by the DRP that the income from settlement of patent infringement cannot become part of operating revenues either on bulk drug manufacturing (API) segment or on product development service (PDS) segment which are two different segments in which assessee is operating and accordingly we agree with the DRP’s stand that this income falls under the category of ‘other income’ and not operating revenue. Not only that the income does not pertain to the relevant financial year nor the costs are incurred in the year under consideration. If without the cost, the income is included in the computation of operational profits, the same gets skewed because of inclusion of extraordinary items. It was decided in number of cases by the Tribunal that incomes of extraordinary nature are to be excluded and further extraordinary events in any company also make it non-comparable while doing exercise of FAR analysis for comparability purpose. For the reasons stated above, we agree with the Assessing Officer/DRP that this income from settlement of patent infringement cannot be considered as operational income while working out the segmental profits or as total profits of the assessee for the purpose of comparison. At best, it can be considered as another segment of income for which no expenditure was charged, but the same cannot be included in either of the segmental operations of the assessee. This ground is accordingly rejected”.

Therefore, though, it is important to note that the item of income or expense should be of the operative nature, but it is also important to see whether the items pertains to segment relating to international transaction? Whether the relevant item have any corelation with international transaction? Whether PLI cannot be computed without considering the item?

7. Conclusion

The Author of this article, in his book[5], made the following important  observations:

“Treatment under the Income Tax Act – TP Provisions

> Exchange gain/loss relating on revenue items, like export and import of trading goods or raw material or services, is considered as revenue in nature and in some of the cases even adjustment for the same is also provided where it is considered as non-operative. Most of these decisions are based on decisions which were decided on non-TP issues. Under TP, one has to determine the ALP of international transactions. The purpose of computing ALP is to check the manipulation in the value of international transactions. Hence, only those items have to be considered, which can affect the value of international transactions and which are in the exclusive domain of the taxpayer. The exchange loss/profit depends on those market forces, which are not in control of taxpayer. To penalise the taxpayer based on government policy does not fit in the scheme of transfer pricing. Even, if it is considered for segmental PLI then also adjustments have to be provided. Where one taxpayer sells goods on credit and other on cash, exchange profits/loss can make huge difference in segmental PLI, if it is considered as operative, even the value of international transactions has same value.”

Therefore, to penalise the taxpayer based on government policy does not fit in the scheme of transfer pricing. Where one taxpayer sells goods on credit and other on cash, exchange profits/loss can make huge difference in segmental PLI, if it is considered as operative, even the value of international transactions has same value. We have tried to explain the situation by taking a very simple example.

For example,  ABC India sold goods to its AE, XYZ Inc. US for USD 10 Million (10,000 KG.).  ABC India also sold exactly same goods to LM Inc. for USD 10 Million (10,000 KG.).  Sale price is receivable in USD in both the cases. When the sale was made, the rate of USD was Rs. 82 and when amount was received after one month from XYZ Inc. it was 83 but when received after twelve months from LM Inc., it was Rs. 88. Therefore, ABC India received Rs. 83 Cr. from XYZ Inc. and received Rs. 88Cr. from LM Inc.

So, the question that arise for consideration is: whether adjustment of Rs. 5 Cr. (88 Cr. – 83 Cr.) should be made if CUP method is applied, considering forex gain as part of selling price? Perhaps, as per Authors, forex gain should not be part of related party transaction, therefore, no adjustment is required.

Under TNM Method, if cost of goods sold were 95% of selling price without considering exchange gain, then the position will be as under:

Therefore, as per Authors, the earning of forex gain or losses is separate transaction which have no correlation with transaction of selling goods.  The authoritative statement of the arm’s length principle is found in paragraph 1 of Article 9 of the OECD Model Tax Convention, which forms the basis of bilateral tax treaties involving OECD member countries and an increasing number of non-member countries. Article 9 provides:

[Where] conditions are made or imposed between the two [associated] enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.

However, forex gain or loss is not based on conditions which are made or imposed between the two AEs only. It is normal transaction which have nothing to do with related parties’ transaction. The exchange loss/profit depends on those market forces, which are not in control of taxpayer. To penalise the taxpayer based on government policy does not fit in the scheme of transfer pricing. Where one taxpayer sells goods on credit and other on cash, exchange profits/loss can make huge difference in segmental PLI, if it is considered as operative, even the value of international transactions has same value.

Therefore, it will be interesting to see whether Government will made specific provisions under law or judicial authorities will took cognizance of this anomaly or the present position will continue?

Reference

[1] CA Hari Om Jindal, is practising in the field of income tax, international tax and transfer pricing for more than 30 years. The author has written many books on income tax and transfer pricing. The author can be reached at hojindal@yahoo.co.in 

[2] Adv. Surya Jindal, is practising in the field of income tax, international tax and transfer pricing. The author can be reached at suryajindal34@gmail.com

[3] which was published by Taxsutra.  Link is given below. https://www.taxsutra.com/tp/experts-corner/why-outstanding-receivable-should-not-be-benchmarked-separate-transaction

[4] Para 11.4 Foreign exchange fluctuation gain/loss, from the book “Transfer Pricing Theory & Practice – Indian Perspective” by Hari Om Jindal – 1st Edition July 2020, published by Wolters Kluwer.

[5] Para 11.9.12 Foreign exchange fluctuation gain/loss, from the book “Transfer Pricing Theory & Practice – Indian Perspective” by Hari Om Jindal – 1st Edition July 2020, published by Wolters Kluwer.

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Disclaimer: Nothing in this paper should be construed or treated as legal advice. We would like to mention that the opinion expressed in this paper is very complex and subjective views of the Authors which may or may not be accepted by administrative or judicial authorities. We would also like to mention that we have commented on some of the observations mentioned in various decisions for the purpose of explaining the provisions, to the best of our knowledge and ability, without undermining the judicial authorities. We would also like to mention that the views expressed in this paper is for academic discussion and development of subject of transfer pricing. Therefore, the readers are requested to take proper legal advice before acting on any of the observations in this paper.