The Indian Transfer Pricing Regulations (i.e. Section 92C of the Income-tax Act, 1961 read with Rule 10B of the Income-tax Rules, 1962) as well as the OECD Transfer Pricing Guidelines provide the following 5 common transfer pricing methods for evaluating the related party transactions undertaken between entities:
1. Comparable Uncontrolled Price (CUP) Method – The CUP method compares the prices of products or services in a controlled transaction (related party transaction) with those of an uncontrolled transaction (between unrelated parties). The method mandatorily requires that other conditions be the same for the controlled and uncontrolled transaction, so that accurate comparison of prices may be made.
2. Resale Price Method (RPM) – The RPM uses the selling price of a product or service, otherwise known as the resale price. This number is then reduced with a gross margin, determined by comparing the gross margins in comparable transactions made by similar but unrelated organizations.
3. Cost Plus Method (CPM) – The CPM uses the gross profits of companies to the overall cost of goods sold to analyse the arm’s length nature of related vis-à-vis unrelated transactions.
4. Profit Split Method (PSM) – When transactions are highly complex such that they cannot be dissected and evaluated separately, PSM is applied by taking into account the activities and contributions of entities in a given value chain.
5. Transactional Net Margin Method (TNMM) – TNMM is the most common method that is used for determining the arm’s length nature of transactions. It compares the operating/ net margins of companies to analyse if the related party transactions have been undertaken on an arm’s length basis.
Additionally, the Income-tax Rules specify that a sixth method i.e. ‘’Óther Method” can be applied when no other method can be reasonably applied to evaluate related party transactions.
In this article, we are going to see how the TNMM is applied. Specifically, in the Indian context,
TNMM is used as well as accepted by nearly all tax authorities and is the most common method for determining whether a transaction is at arm’s length.
As its name suggests, TNMM compares the net operating profit margin of a company vis-à-vis comparable companies. One strength of TNMM is that comparable companies can be selected from a broad range of criteria. For instance, comparable companies can be chosen from the same industry, undertaking similar functions, selling the same products or services etc. This inherent strength of the method makes it easy to find comparable companies and reasonably determine the arm’s length nature of related as well as unrelated transactions.
Step 1: Conducting Functions, Assets & Risks Analysis (FAR)
The foremost step in conducting ant transfer pricing analysis including TNMM analysis is understanding the functions performed, assets used and risk assumed (commonly known as FAR analysis) by the parties relevant to the transaction. For this, one should take an in-depth understanding of the activities that are undertaken by the parties involved in the transaction. For instance, if ABC Inc. undertakes a transaction of availing payroll services from its subsidiary in India namely, ABC Ltd., the activities performed by ABC Inc. and ABC Ltd. in relation to the transaction of payroll services should be understood very carefully.
Step 2: Find out the tested party
Once we have conducted the FAR analysis, the second step is to find out who the tested party is. As per the OECD guidelines as well as the Indian transfer pricing guidelines, the entity that has the least complex activities should be taken as the tested party. For instance, ABC Inc. is an IT company based out of US and ABC Ltd. is its subsidiary in India providing renders routine back-end services to the ABC Inc. without any value addition. In this example, ABC Ltd. would be the less complex entity since its activities are least complex in nature. Hence, ABC Ltd. would be he tested party in this case.
Step 3: Find out the Profit Level Indicator (PLI)
Next step is to determine the appropriate PLI. PLI is the ratio of net operating profit relative to a base, such as “costs,” “sales” or “assets.” Depending on the kind of company we are dealing with the PLI is chosen.
For example, total costs or operational costs may be appropriate for the rendering of services or manufacturing activity, while the operating assets may be an adequate base for the activities requiring much capital, such as certain manufacturing activities or specific infrastructural services.
Step 4: Conducting benchmarking using public databases
Once the tested party and PLI is finalised, a benchmarking study is done in which companies similar to the tested party are searched and their operating net margins are calculated. For this, public database containing financial and qualitative information about Indian companies are accessed. Some of the common databases used in India and well as Income-tax officers include Prowess, Capitaline, AceTP etc.
A proper search strategy is developed wherein all the quantitative metrics are defined. According to the search strategy companies are extracted which are the evaluated on qualitative parameters one by one. Finally, the companies that pass both the financial and qualitative parameters form part of the final set of comparable companies.
The operating net margins with the relevant base chosen in step 3 are calculated for the said companies and then compared with the margins of the tested party. If the margins of the comparable companies are in line with the margins of the tested party, the related party transactions undertaken by the tested party are considered to be at arm’s length.
Needless to mention, benchmarking using TNMM is a very subjective exercise. What may be a comparable company for one may not be a comparable company for someone else. This is exactly why there is so much litigation around the correct comparability criteria and the comparable companies adopted by companies to benchmark its margins. It is not new to see transfer pricing officers creating their own search strategy and making a set of comparable companies that have higher margins leading to addition to taxable income. Hence, the exercise should be conducted with utmost care.