Video Tutorial on Transfer Pricing (Working Capital Adjustment)

Nilesh Patel – CPA (USA), IRS (Former)

Under the Indian Transfer Pricing Regulations (Sec. 92 to Sec. 92F and Sec. 94A of the I.T. Act 1961; and Rules 10A to 10TG of the I.T. Rules 1962) the transactions of intra-group transfers of goods, services, assets, and capital – between related parties and associated enterprises –must be at Arm’s Length Price. The Arm’s Length Price is the price at which comparable independent enterprises operating in the open market undertake comparable transactions.

Information about such price, the price at which comparable independent enterprises undertake comparable transactions, however, is rarely available. So six different Transfer Pricing methods have been prescribed under the Indian Transfer Pricing Regulations: Comparable Uncontrolled Price (CUP), Resale Price Method (RPM), CPM (Cost Plus Method), PSM (Profit Split Method), TNMM (Transactional Net Margin Method) and the Other Method.

In practice we often have to derive Arm’s Length Price by applying TNMM, because limited data of independent enterprises is available in public domain. Under TNMM we compare Operating Profit Margin (OPM) of independent enterprises with the OPM of the Taxpayer. For example, if the Taxpayer is a pharma manufacturer then we will search for other similar pharma manufacturers, and compare the Taxpayer’s OPM with the OPM of those other pharma manufacturers.

But are the OPMs of two pharma manufacturers really comparable? No two pharma manufacturers will perform identical functions, employ identical assets and bear identical risks (FAR profile). There will be some difference in functions performed, assets employed and risks borne by the two pharma manufacturers, or, for that matter,by any two business enterprises. Such difference adversely affects the reliability of the results of comparison of OPM of two business enterprises. And that could lead to erroneous computation of the Arm’s Length Price – for reliable results the comparison of OPMs should be between enterprises that have comparable FAR profile.

For example, a Software Development Services Provider who performs more value-adding functions and bears higher risks, as compared to the Taxpayer (another Software Development Services Provider), will generally earn higher levels of OPM than the Taxpayer. So, the Arm’s Length Price, computed on basis of comparison between the OPMs of these two service providers, will be unreliable. Why? Because the effect of difference in FAR profile of two enterprises creeps into the comparison. As already stated, the comparison of OPM should be made between enterprises who have similar FAR profile.

How do we rectify the situation? Is there a remedy? How do we ensure a reliable comparison between the Taxpayer and the independent enterprises?

To make a reliable comparison we will have to remove the effect – on OPM – of the difference in the FAR profiles of the Taxpayer and independent enterprises. How do we do that? We make suitable economic adjustments. And one of the most important economic adjustments that we can make is Working Capital Adjustment.

What is Working Capital Adjustment? What is its relevance in determining the Arm’s Length Price? Do the I.T. Act 1961 or the I.T. Rules 1962 permit us to make Working Capital Adjustment? In what way can a Working Capital Adjustment help us in our Transfer Pricing assignments? How do we make Working Capital Adjustment in real Transfer Pricing cases?

Answers to these questions are explored in this Video Tutorial. The Tutorial shows you how to make Working Capital Adjustment in real Transfer Pricing cases. It explains – with simple examples – the economic concept underlying Working Capital Adjustment. It tells you about the observations made by ICAI Guidance Note on Transfer Pricing Audit, OECD Transfer Pricing Guidelines and UN Transfer Pricing Manual on Working Capital Adjustment. The Tutorial also discusses relevant ITAT decisions. In the end it takes you through a full-fledged example of computation of Working Capital Adjustment.

After watching this Video Tutorial you will be able to make and claim Working Capital Adjustment in your Transfer Pricing assignments. Also, you will be able to defend such claim before the Transfer Pricing Officer.

For your convenience the entire Video Tutorial is divided in five parts.

Below are the Topics covered in each Part:

Part I – Introduction. The concept of Working Capital Adjustment is introduced. The need for Working Capital Adjustment is established.

Part II – Discussion of the economic rationale for Working Capital Adjustment. What exactly Working Capital Adjustment is? What is the need for making Working Capital Adjustment? All this is explained through a simple example.

Part III – The mechanism of making Working Capital Adjustment. How to actually make Working Capital Adjustment in real Transfer Pricing cases. This is illustrated by a numerical example.

Part VI – Legal and Regulatory support for Working Capital Adjustment.

a) What are the relevant provisions of the I.T. Act 1961 and I.T. Rues 1962?

b)What do following Guidelines tell us about Working Capital Adjustment?

• ICAI Guidance Note on Report under Sec. 92E
• OECD Transfer Pricing Guidelines
• UN Practice Manual on Transfer Pricing

c) ITAT decisions on Working Capital Adjustment

Part V – Full-fledged Example based on OECD Transfer Pricing Guidelines and UN Practice Manual on Transfer Pricing, showing how to actually compute and make Working Capital Adjustment in real cases. The Tutorial closes with a brief discussion of different types of adjustments, other than Working Capital Adjustment.