INTRODUCTION
Benchmarking, in layman’s terms would be laying down the boundaries or the limits which serve as the basis or the baseline from where the performance of a company’s products, services, or processes against those of another business are measured. In the context of Transfer Pricing, this process is applied to test whether a transaction has been done at an Arm’s length price or not.
It becomes essential to undertake the benchmarking process, especially in situations of transactions between a company (parent or holding company) with its Associated Enterprise (subsidiary)
Thus, what benchmarking essentially does is, it enables the one conducting the Transfer pricing or arms-length pricing study to select a comparable from the material available to reach a decision rationally basis the financial data of the selected comparable. It cannot be denied that a well-done benchmarking analysis is the backbone of TP documentation. It goes on to play a crucial role in justifying that the transfer price has been determined as per the arm’s length principle.
In the Indian scenario, the Transfer pricing rules were introduced in the year 2001 and Rule 10D of the income tax rules makes it mandatory to maintain a record concerning analysis performed to evaluate the comparability of uncontrolled transactions. Rule 10DA was further added in the year 2017 and amended as recently in 2020, which requires maintenance of even more documentation if the company is a part of an international group of companies. Thus, it can be said that benchmarking Analysis as part of Transfer Pricing Documentation comes up in the form of the first line of defense.
For this article, Rule 10D assumes importance and it lists the documents that need to be maintained and are as follows:
(a) a description of the ownership structure of the assessee enterprise with details of shares or other ownership interest held therein by other enterprises;
(b) a profile of the multinational group of which the assessee enterprise is a part along with the name, address, legal status, and country of tax residence of each of the enterprises comprised in the group with whom international transactions or domestic transactions have been entered into by the assessee, and ownership linkages among them;
(c) a broad description of the business of the assessee and the industry in which the assessee operates, and of the business of the associated enterprises with whom the assessee has transacted;
(d) the nature and terms of the transactions whether international or domestic entered into with each associated enterprise, details of property transferred or services provided, and the quantum and the value of each such transaction or class of such transaction;
(e) a description of the functions performed, risks assumed and assets employed or to be employed by the assessee and by the associated enterprises involved in the international transaction [or the specified domestic transaction] ;
(f) a record of the economic and market analyses, forecasts, budgets, or any other financial estimates so prepared for the business as a whole and for each division or product separately, which may have a bearing on the transactions that may have been entered into;
(g) a record of uncontrolled transactions taken into account for analyzing their comparability with the international or domestic transactions entered into, including a record of the nature, terms, and conditions relating to any uncontrolled transaction with third parties which may be of relevance to the pricing structure
(h) a record of the analysis performed to evaluate the comparability of uncontrolled transactions with the relevant international transaction [or specified domestic transaction] ;
(i) a description of the methods considered for determining the arm’s length price about each transaction or a class of transactions, the method selected as the most appropriate method along with explanations as to why such method was so selected, and how such method was applied in each case;
(j) a record of the actual working carried out for determining the arm’s length price, including details of the comparable data and financial information used in applying the most appropriate method, and adjustments which were made to account for differences between the international or domestic transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions;
(k) the assumptions, policies and price negotiations, if any, which have critically affected the determination of the arm’s length price;
(l) details of the adjustments, if any, made to transfer prices to align them with arm’s length prices determined under these rules and consequent adjustment made to the total income for tax purposes;
(m) any other information, data or document, including information or data relating to the associated enterprise, which may be relevant for determination of the arm’s length price.
Basis the information that is contained in these documents the benchmarking process is carried out and it involves majorly:
a) Determination of years to be covered
b) Analysis of taxpayer circumstances
c) Understanding of controlled transactions on the basis of FAR Analysis
d) Review of Internal Comparables, if any
e) Identifying sources for external comparables, wherever existing and possible
f) Selection of the most appropriate method and Profit Level Indicators
g) Identification of potential comparables after applying the filters
h) Determining the comparability adjustments required to be made
i) Interpretation of results and finally use of collected data and arrive at Arm’s Length Price (ALP)
THE INDIAN CONTEXT
To understand how benchmarking and its processes have evolved from when these rules were brought into force, we take the help of the rulings provided by various tribunals and courts from time to time.
1. Reimbursement of expenses
The Delhi High Court in the case of Cushman and Wakefield India Pvt Ltd held that the mere cost recharge without mark-up requires no benchmarking analysis. Since uncontrolled transactions would involve a mark-up and lead to higher price. Cost incurred in an uncontrolled transaction cannot be speculated to be higher on account of mark-up. Whether the cost charged by the AE is inflated or not is required to be tested explicitly by undertaking a benchmarking analysis.
This judgment thus, helps us understand the need for analysis and the maintenance of documentary evidence to demonstrate receipt of service, basis of the cost incurred, activities for which they were incurred, benefits directly related to such activities, etc. for providing validity of claim and determination of ALP
2. Geographical location
In the case of Bharti Airtel Ltd. vs. ACIT , the Delhi ITAT, held that the geographical location of the market is of no consequence in judging the comparability of an uncontrolled transaction for purpose of applying the CUP method, unless market conditions, in which uncontrolled transactions have taken place, are materially different vis-à-vis conditions in which international transaction has taken place.
This case further highlights the need for benchmarking as it highlights that The decisive factor, based on which comparability is to be judged, is the state of ‘conditions prevailing in the markets in which the respective transactions to the parties operate’. These conditions could be including (a) geographical location and size of the market; (b) overall economic development and level of competition in the market; and (c) whether the market are wholesale or retail.
Thus, having the data for the above conditions helps us to identify whether the marketplace where these transactions have taken place is materially different from the marketplace which is being tested for the ALP.
3. Cost in cost-plus method
‘Cost’ in the cost-plus method means actual costs and not estimated costs. The Mumbai Tribunal in Reliance Industries Ltd. Vs. Addl. CIT held that actual costs have to be taken to arrive at the correct cost. Only then cost plus method can be applied.
The Hyderabad Tribunal in the case of Alumeco India Extrusion Ltd vs ACIT rejected the application of TNMM by the department and held that there were significant domestic sales to non-AE of similar product. Therefore, held that internal domestic transaction could be used for benchmarking domestic transactions are similar to the export transactions.
4. Internal v external comparable
The case of Birlasoft (India) Ltd. vs. DCIT reiterates the preference of internal comparables over external comparables. This is clear when the court held that the Transfer Pricing Officer had no mandate to have recourse to external comparables when, in the present case, internal comparables were available, which could be applied for determining the arm’s length price of international transactions with AEs
This helps us to see that the Indian Transfer pricing community for the benchmarking analysis prefers that the data that is already available, in this case, domestic transaction data, should be utilized first.
Nexus between Indian TP Regulations & The Companies Act 2013
The companies act of 2013 introduced the arm’s length concept for Related party transactions. With the introduction of this concept, the Companies in compliance of the act also need to assess whether their related party transactions comply with the arm’s length concept and then evaluate and report the same under the act. Thus, previously the arm’s length concept was hitherto used only under Indian Transfer Pricing Regulations, however, now even the related party transactions covered under the provisions of the Companies Act may now call for benchmarking.
Thus, it can be concluded that the Indian Transfer Pricing community, believes majorly on 2 things i.e maintaining documentation and proper reporting and compliance; and taking the support of domestic comparables first, rather than simply jumping on international comparables.
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