Transfer Pricing: Identification of Tested Party, whether assessee or associated enterprise

Transfer pricing is the concept where a controlled transaction between two associated enterprises (AEs) is compared with an uncontrolled transaction under the similar circumstances in respect of price or margin. The process of transfer pricing is consist of two analysis i.e. Financial analysis and Economic analysis.

Financial analysis which is also known as FAR analysis is the analysis of function carried out, assets used and risks assumed by the enterprises involved in the transaction, while the economic analysis is the determination of Arm’s Length price or margin. In the Economic analysis the entity whose profit margin is taken up for comparison is known as the ‘TESTED PARTY’. Which party should be taken as tested party, the assessee or the associated enterprise? Identification of the tested party is very important as it also determines the selection of comparables. After the introduction of Domestic Transfer Pricing in India, the identification of tested party has become more important as in this case now both of the parties will be Indian Parties.

The selection of the tested party is a matter of dispute since beginning of the introduction of transfer pricing in India as the Indian Income Tax Act. 1961 (‘Act’) does not define the concept of ‘Tested Party’. However, OECD has defined in detail the concept of tested party in its guidelines for Multinational Enterprises and Tax Administration. Further the same has also been defined in UN Manual.

The OECD Guidelines defines ‘tested party’ as “the one to which a transfer pricing method can be applied in the most reliable manner and for which the most reliable comparable can be found, i.e. it will most often be the one that has the less complex functional analysis.” UN Manual defines tested party in the similar manner. A Tested party should have the following attributes on bases of these definitions:

1. Available of reliable and accurate data for comparison
2. Least Complex (amongst the parties to the transaction)
3. Data available can be used with minimal adjustments.

To understand this concept in detail I will discuss two caselaws depending on the same concept:

In the case of General Motor India Pvt Ltd [ITA nos. 3096/AHD/2010 and 3308/AHD/2011] [ASSESSMENT YEARS 2006-07 AND 2007-08] AUGUST 2, 2013, the ITAT bench of Ahmedabad has held that tested party should be the least complex entity for which reliable data in respect of itself and in respect of comparables is available. The Tribunal accepted that tested party could be the local entity or a foreign associate enterprise (AE), and upheld selection of foreign AE as tested party in the instant case. It also implicitly held that the tested party should be determined based on the international transaction rather than the entities as a whole. Further, it re-emphasizes the importance of a detailed FAR (functions, assets and risks) analysis to determine the least complex entity. The brief fact of the case are as under:

The General Motor India Pvt. Ltd. (“GMIPL”) was engaged in manufacture and trading of automobiles and its parts. GMIPL used to imports finished vehicles kits (CKD kits) from its foreign entity for manufacturing cars and selling them in the Indian market.  It also purchased spare parts from foreign entity for resale in India.

1. With regard to this international transaction relating to import of CKD kits, GMIPL characterized itself as an “entrepreneur”, whereas the foreign entity was characterized as a “contract manufacturer” assuming limited risks. Hence, based on this, foreign entity was selected as the “tested party” and was benchmarked using foreign comparables companies.

2. This approach of GMIPL was challenged and rejected by the Transfer Pricing Officer (TPO) as well as Dispute Resolution Panel (DRP), inter alia, argued that GMIPL was lesser complex entity and that data for verifying foreign tested party and comparables were not available.

The Ahmedabad ITAT pronounced its judgment in favor of GMIPL by concluding that,

1. A foreign entity can be selected as the tested party.

2. The entity to be selected as the “tested party” should be the least complex and not necessarily unique.

3. Rejection of foreign entity as “tested party” on the ground that comparable companies selected doesn’t fall within the ambit of the Income Tax Authorities’ jurisdiction is not correct. Also, the contention that data would not be reliable or easily available was rejected, since the same was provided by GMIPL and was audited by an independent auditor.

4. The UN Manual and the OECD Guidelines, which clearly supported the view that the least complex entity should be selected as the “tested party” was also referred.

5. It  highlighted conflicting stand taken by the authorities, wherein for determining the arm’s length price of the royalty transaction the foreign entity was accepted as the “tested party

However in the Judgment of Aurionpro Solutions Ltd. vs. ACIT, Range – 4(3), Mumbai, ITA No. 7872 (Mum.) of 2011, ITAT Mumbai has held that for purpose of determination of Arm’s Length Price, tested party is always assessee and not its Associate Enterprise (AE) but the facts were different in that case.

The Ahmedabad ITAT has discussed the concept of TESTED PARTY in detail in the case of General Motor India Pvt. Ltd and it is concluded that this decision may settle the dispute regarding selection of the tested party. The crux of the case is that the assessee should ensure that while maintaining TP documentation, all the requisite criteria are met and since the onus of selecting foreign entity as “tested party” would be on the taxpayer, proper records and documents to demonstrate the same should also be maintained. The ITAT in the instant case has given importance to an independent audit and review of such data. Data availability in respect of the Associated Enterprise and comparables is the other important requisite when selecting an Associated Enterprise as tested party.