[Submitted by Ms. Priyanka Garg,
CA Final Student,

September 9, 2008

1 Introduction

1.1 The lopsided distribution of economic resources between different countries is the basis of international trade. With increasing globalization, related party transactions between Multinational Enterprises (MNEs), which account for almost 60 per cent of all international transactions, necessitated the concept of Transfer Pricing (TP). TP is typically used in situations where MNEs seek to cut their tax base by artificially shifting the profits from higher tax jurisdictions to lower tax jurisdictions without a considerable change in business operations. The TP regime may even be manipulated by small organizations engaging in cross border transactions with affiliated entities. A less developed country is more likely to suffer due to TP manipulation than a developed country because of the lack of adequate resources and the inability to monitor transactions.

1.2 In this paper, I shall discuss briefly the concept of transfer pricing, the implications of its manipulation, and attempt to give recommendations for improving the Indian TP regime.

2 The Concept

2.1 TP relates to the pricing of transactions (such as transfer of goods, services, intangibles and funds) that take place within affiliate segments of a group company in different tax jurisdictions. To illustrate this, let us suppose a subsidiary company, resident in country 'A' (which has a tax rate of, say, 40%) manufactures goods and transfers them to its parent company in country 'B' (which has a tax rate of 20%) for trading. In order to increase the overall profits of the group company, it will seek to supply the goods at prices which are lower than the market price. So, in effect, the subsidiary company in country 'A' will have lower profits and [therefore,] a lower tax incidence whereas the parent company in country 'B' is affected in the opposite manner - higher profits due to low costs, but lower taxes because of the tax rate - which illustrates the importance of TP from a taxation perspective. However, TP transactions can be much more complex than the example above and usually involve deliberations on inter related variables and the weighing of regulatory and other constraints.

2.2 Nowadays, tax revenue authorities have become more vigilant about TP issues as TP transactions form a considerable part of the tax base of all countries. Compared to other countries, India is a late entrant in the field of regulating TP. The Finance Act, 2001 introduced provisions regulating TP in the Income Tax Act, 1961 with effect from 1 April, 2001. Prior to this amendment, a limited provision regulating transfer pricing did exist in section 92 of the Act. However, this was very often not strictly complied with by businesses as there were no rules or guidance available regarding its implementation. However, the 2001 amendment, which defined 'associated enterprise' and 'international transaction' for the first time, has brought much needed clarity to the law. There is greater respect among businesses (including MNEs) for the expertise of the Indian tax authorities in handling the complexities involved in TP transactions.

2.3 MNEs have to keep in mind multiple factors in deciding their TP strategies. Some of them are:

2.3.1 Tax jurisdiction: Profit is a function of price. As a result, charging higher prices in a higher tax jurisdiction results in a low tax base and relatively higher profits in a lower tax jurisdiction.

2.3.2 Import duties: Usually, low prices of commodities attract low import duties in countries where custom duties form a major part of tax revenues.

2.3.3 Thin Capitalization: MNEs also have the option of thinly capitalizing some of its constituent entities by making investments as loans instead of equity to avail tax benefits. This mechanism would usually involve a foreign affiliate of a group company making an investment in a domestic affiliate of the company in the form of loans. As a result, the company's debt-equity ratio increases, i.e. it becomes thinly capitalized. Thin capitalization can be part of a larger TP strategy. MNEs make iniquitous use of this method to avail of tax benefits since interest on loans is deductible while calculating taxable income. In India, there is no formalized provision regulating thin capitalization under the law, but there are some related provisions regarding permissible debt in the Foreign Exchange Management Act, 1999 (FEMA), which act as alternative mechanisms to reduce such practices.

2.3.4 Others: Other methods include the exploitation of fluctuations in foreign exchange rates to derive maximum benefit. For instance, a company can reduce the expected currency devaluation risk by transferring funds to its affiliates in other countries and varying the cash flow requirements of the companies within MNEs. The MNE group may be pressurised by shareholders to show high profitability at the parent company level, particularly if financial reporting is not carried out on a consolidated basis.

3 Methods for calculating arm's length price

3.1 To counter TP manipulations, the Organization of Economic Cooperation & Development (OECD) introduced the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations in 1995. These guidelines are respected worldwide and the Indian TP regime is primarily based on them, though with a few customized features. Under the TP regime, the transfer price has to be determined on the basis of the arm's length principle and the price so determined is the Arm's Length Price (ALP). According to the arm's length principle, there are two sets of methods for arriving at the ALP:

3.1.1 Transactional methods: These methods emphasize each transaction specifically rather than considering the overall profit figure of related entities to arrive at the ALP. These are:

  • Comparable Uncontrolled Prices method (CUP): Under this method, price charged in an uncontrolled transaction between comparable entities is identified and compared with the tested entity price (after making due adjustments in relation to terms and conditions and risk involved) to determine the ALP.
  • Cost Plus Method (CPM): Here, the total cost of production incurred by the tested enterprise in transferring goods and services to Associated Enterprises (AEs) is calculated and the total gross profit mark up used by comparable entities in similar transactions with independent enterprises is determined. The total gross mark-up arrived at is adjusted to take into account functional and other differences to determine ALP.
  • Resale Price Method (RPM): This method is similar to CPM and is used where the seller adds relatively little or no value to products acquired from AEs. Here, ALP is determined by subtracting the appropriate gross profit mark-up from the sale price charged to an independent entity. The appropriate gross margin is determined by comparing the gross margin of comparable entities with the tested enterprise, after making necessary adjustments regarding functional and other differences.

3.1.2 Non transactional methods: In non transactional methods, related parties income figures are considered and adjusted according to their share. These are:

  • Profit Split Method (PSM): PSM is used when AEs' transactions are so integrated that it becomes impossible to conduct a TP analysis on a transactional basis. First, the combined net profit incurring to related enterprises from a transaction is determined. Then, the combined net profit is allocated between related enterprises with reference to market returns achieved by independent entities in similar transactions. The relative contribution of related parties is then evaluated on the basis of assets employed, functions performed or to be performed and risk assumed.
  • Transactional Net Margin Method (TNMM): TNMM is normally adopted in cases of transfer of semi-finished goods, distribution of finished products (where resale price method (RPM) cannot be adequately applied) and transactions involving the provision of services. TNMM compares the net profit margin relative to an appropriate base (sales, assets or costs incurred) of the tested party with net profit margin of the independent enterprises in similar transactions after making adjustments regarding functional differences and risk involved.

3.2 Under the Indian TP regime, there is no hierarchy in terms of preferred methods of determining ALP. Indeed, as per section 92C (2) of the Income Tax 1961, the most appropriate method has to be applied for determining ALP in the manner prescribed under Rules 10 A to 10C notified vide S.O. 808 E dated 21.8.2001.

4 Procedural aspects of determining ALP:

An example would be useful in understanding the procedure for calculating ALP. Let us suppose a subsidiary company 'A' in India is importing manufactured goods from parent company 'B' in France for the purpose of trading the goods in India. There is no public information available regarding prices charged by companies engaged in similar activities. To calculate ALP, we will have to select most appropriate method after taking into consideration the various aspects described below:

4.1 Finding uncontrolled comparable data:

4.1.1 The first step would be to access databases like Prowess and Capitaline Plus, two commercial databases available in India which contain financial and non-financial information gathered from audited annual accounts, stock exchanges, company announcements, etc of over 10,000 small and mid-sized companies. Let us suppose that to find comparable companies, a search for companies engaged in similar business is first run in Prowess which shows say 200 companies with comparable transactions. Then say the same procedure is followed in Capitaline Plus database from where we get 100 companies. We would now have to compare the results from the two electronic databases to exclude companies which form part of both searches and say we get 110 comparable companies.

4.1.2 These comparable companies would then be screened on a qualitative basis (for instance on the basis of the exclusion of sick units, related party transactions and functionally different units) and quantitative basis (for instance, transaction thresholds, turnover thresholds etc.) and say, finally we get 15 companies for comparison with company A.

4.2 Selection of most appropriate method:

4.2.1 Cost plus method (CPM): Since the CPM method is usually used where semi finished goods are transferred, it will not be applicable to our example.

4.2.2 Comparable Uncontrolled Prices Method (CUP): The CUP is not applicable as no public information is available regarding prices charged by independent companies in import of similar goods.

4.2.3 Resale Price Method (RPM): RPM is used where the seller adds relatively little or no value to products acquired from AEs. In the present case RPM may be taken as the most appropriate method as comparable data of similar transactions by independent entities is available.

4.2.4 Profit Split method (PSM): This method is used when AEs transactions are so integrated that it becomes impossible to make TP analysis on transactional basis, which is not the case in our example.

4.2.5 Transactional Net Margin Method (TNMM): TNMM is normally adopted in the case of transfer of semi finished goods, distribution of finished products and where resale price method (RPM) cannot be adequately applied. However, since RPM can be more appropriately applied in this case, TNMM is also not appropriate.

4.3 Calculation of ALP: Now the most appropriate method, which is RPM in this case, is applied to calculate the ALP. Since data is available for 15 comparable companies, we would take arithmetic mean of prices of charged by such companies for similar goods and this arithmetic mean, or a price which differs from arithmetic mean by +-5%, will be taken as the ALP for company 'A'.

5 Significant factors while calculating ALP:

5.1 Risk Analysis: In India, tax authorities often err on the side of caution and transfer pricing officers (TPOs) have largely ignored the importance of risk in TP analysis in many cases. It is a fundamental principle of economics that enterprises which undertake low risk can expect only to yield low profits. This was also acknowledged by Delhi Income Tax Appellate Tribunal (ITAT) in its recent landmark decision of Mentor Graphics (Noida) Private Limited v. Dy. CIT ITA, NO. 1969/D/2006 which has revived the hopes of taxpayers. Mentor Graphics Private Limited (Noida) was engaged in the business of software development and rendering marketing systems services to its parent company, IKOS Systems Inc. in USA. It charged for its software development services by using TNMM as the most appropriate method and used Net Cost Profit (NCP) as the price level indicator to its US parent company (in this case, NCP of 6.99%). However, placing reliance on the TPO's order, the Assessing Officer accepted the revised NCP at 23.53% and accordingly made an adjustment of Rs.14.5 million to the company's taxable income which was upheld by the Commissioner (Appeals). However, ITAT, in its decision, concluded that search conducted by the TPO had serious defects affecting the ALP and ruled that the decision was incorrect. Therefore the price disclosed by the assessee was considered as the ALP and the addition of Rs.14.5 million was rejected. ITAT emphasized that appropriate adjustments relating to functional, asset and risk differences are necessary while choosing comparable enterprises in TP analyses.

5.2 Use of secret data: In many developed countries, use of secret data while carrying out assessments is prohibited. However in India, this information may be used by tax authorities against tax payers.

5.3 Transactions involving intangibles: At present TP regulations have no specific provisions for transfer of intangibles and the five prescribed methods are often found inadequate to deal with TP issues relating to intangibles.

6 Recommendations:

6.1 Advance Pricing Agreement (APA): In some jurisdictions, in order to resolve complex TP issues, taxpayers may agree with the appropriate tax authority that future transactions will be conducted at an agreed price which will be deemed as the ALP for those transactions. For instance, UK legislation provides that a UK business may agree the ALP with Her Majesty's Revenue & Customs (HMRC) but it will run the risk of being assessed by foreign tax authorities relating to the method of calculation of the ALP. Bilateral or multilateral agreements, which eliminate risk of double taxation are also in existence in certain other developed countries, but there is no provision for such agreements in India as of now. APA places a company in a better position by predicting costs and expenses including tax liabilities. It limits the prospect of potentially costly and time consuming examination of major TP issues that would arise in TP audit and also substantially reduces or eliminates the possibility of double taxation. By promulgation of the amendment regarding APA, government can reduce TP problems to a great extent.

6.2 Databases: In India, as mentioned earlier, two commercial databases (Prowess and Capitaline Plus) are available which contain financial information of about 10,000 public and private companies. However, these databases are not primarily designed for TP analyses. If these databases are made suitable for TP analysis in terms of improvement of search parameters, increase in the size of the databases etc., finding comparable transactions for determination of ALP would become much easier.
6.3 Risk differences: While the ruling laid in Mentor Graphics case (as discussed above) acknowledges the risk differences to be considered for TP analysis, no guidance has been provided on the correct approach for making risk adjustments. If appropriate guidance for making such adjustments is provided, key TP issues can be resolved.