TRANSFER PRICING: A DETAILED STUDY ON DETERMINATION OF ARM’S LENGTH PRICE (ALP) BY MOST APPROPRIATE METHOD (MAM)

India, a global market is emerging everyday with its ever- increasing economic activities and participation of many multi-national groups. Whenever there is an international transaction taking place between two associated enterprises, a market price is set up, known as transfer pricing. When two unrelated enterprises trade with each other, they do so at a market price for the transaction known as Arms Length Price. This paper deploys Transfer Pricing concept to elaborate on the various methods for the calculation of Arm’s Length Price (ALP) prescribed by the Income Tax Act, 1951 and to opt for the Most Appropriate Method (MAM). This paper bifurcates the transactions based on the types of industries and accordingly provides for The Most Appropriate Method in a given transaction. In the concluding part, the researcher puts forth that for every cross- border transaction, the Indian transfer pricing code provides a most suitable method for calculating the Arm’s Length Price.

KEY WORDS: Transfer Pricing, Arm’s Length Price (ALP), Most Appropriate Method (MAM), industries, functions.

                                                 

INTRODUCTION

Transfer pricing happens whenever there is an international transaction taking place between two associated enterprises, like, when a US-based subsidiary of Coca-Cola, for example, buys something from a French-based subsidiary of Coca-Cola. This international transaction needs a market price to be established for it to be carried out. When the parties establish a price for the transaction, this is transfer pricing. When two unrelated enterprises trade with each other, they do so at a market price for the transaction known as Arms Length Price. [1] The Indian Transfer Pricing Code prescribes that income arising from international transactions or specified domestic transactions between associated enterprises should be computed having regard to the arm’s-length price.[2] For ALP to be determined, an analysis of the functions that are performed, assets employed and risks assumed by the company with respect to the subject transaction is carried out.  Based on various factors which include availability of comparable information, the most appropriate method (MAM) is selected and probable comparables are identified.[3]

The arm’s length price with respect to international transaction is determined by the following methods, one of them being the MAM, having regard to the nature/class of the transactions or class of AE or functions performed, namely

 ► Comparable Uncontrolled Price (‘CUP’) method,

 ► Resale Price Method (‘RPM’)

► Cost Plus Method (‘CPM’)

► Profit Split Method (‘’PSM)

► Transactional Net Margin Method (‘TNMM’)

► Such other method as may be prescribed by the Board (None as of now)

The Central Board of Direct Taxes in respect to the other methods has prescribed that for determining of the arm’s-length price in relation to an international transaction, any method which takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts.

No order of priority has been set for selection of methods. The taxpayers are bestowed with the option to choose the Most Appropriate Method. The methodologies prescribed are with the OECD Guidelines. Rules 10B and 10AB describe the TP methods. Where more than one method can be applied the ALP shall be calculated on average mean of all such computations[4]

MOST APPROPRIATE METHOD (MAM) FOR DIFFERENT TYPES OF INDUSTRIES

To calculate the arm’s length price, the industries are divided upon the functions that are performed or the activities carried out by each of the parties to transaction. The significant functions that are performed by the entities add more value to the transactions. The different kinds of industry as per the functions are as follows:

 

INDUSRTY

 

CUP

 

CPM

 

RPM

 

PSM

 

TNMM

 

Research and development

REASON: TNMM is considered the best method for partially completed products and distribution of completed goods.

 

 

 

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Generic drugs

REASON: this method is generally used in the industries where semi finished products are transferred because the mark-up on costs that the manufacturer or service provider earns from the controlled transaction is compared with the mark-up on costs from comparable uncontrolled transactions.  The cost plus method would normally be adopted if CUP method or resale price method cannot be applied to a specific transaction or where goods are sold between associates at such stage where uncontrolled price is not available or where there are long term buy and supply arrangements or in the case of provision of services or contract manufacturing.

 

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Manufacturing, production and process engineering and designing work

 

REASON: TNMM is considered the best method for partially completed products and distribution of completed goods.

CPM is generally used in the industries where semi finished products are transferred

 

 

 

 

 

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Intra‐group services / Support services.

 

REASON: It is used for semi furnished goods.

 

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Marketing, advertising, publicity and distribution;

REASON: In this method the vendor adds comparatively small or no value to goods taken from associate enterprises. It resells products without physically altering them.

 

 

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Transportation, warehousing and inventory

REASON: In the absence of actual transaction, the data available in the public domain can be considered as a ‘comparable price’ after making adjustment for the differences.

 

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pharmaceutical/financial/telecom

 

REASON: This method is used when associate enterprises are so combined that it turns difficult to divide international. Also, for long term and supply arrangements.

 

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EXAMPLES AND CASES

COMPARABLE UNCONTROLLED PRICES METHOD (CUP):

EXAMPLE: 

  • If A Ltd. purchases chemical X from B Ltd. (related party) as well as C Ltd. (unrelated party), then price paid to unrelated party can be used for bench marking if other terms are comparable

 

  • A Ltd. purchases chemical X only from B Ltd. However, if B Ltd. sells chemical X to A Ltd as well as C Ltd., then it can also be used for bench marking if other terms are comparable

CASE:

  • Serdia Pharmaceuticals (India) Private Limited  ACIT[5]

The assessee, a pharmaceutical company, imported ‘Active Pharmaceutical Ingredient’ (‘API’s) from its foreign associated enterprises (‘AE’) and used them for manufacture of drugs. For transfer pricing purposes, the assessee adopted the ‘Transactional Net Margin Method’ (“TNMM”) as the most appropriate method and claimed that its transactions with the AE’s were at arms length on the basis that the assessee’s operating profit at 8.76% on net sales was higher than that of its comparable competitors. However, the TPO held that the assessee had purchased the APIs from the AE’s at prices that were higher than that paid for similar APIs by other companies in India. He rejected the contention of the assessee that the higher prices paid by the assessee were justified owing to their superior quality. The TPO held that the TNMM was not a “reliable” method and that the Comparable Uncontrolled Price (‘CUP’) was, on facts, the most appropriate method and computed the arms’ length price (‘ALP’) on that basis. On appeal, the CIT (A) upheld the stand of the TPO. On further appeal by the assessee, the Mumbai Tribunal dismissed the appeal of the assessee on the ground that for generic drugs, CUP is appropriate method despite quality differences.

  • Maruti Suzuki India Ltd case[6]

This is a landmark case on the issue of marketing intangibles in the Indian transfer pricing landscape. If the licensed manufacturer contributes to creation of and also economically owns marketing intangibles arising out of advertising and marketing expenses, then it would be entitled to rewards arising out of such spend and thus not required to be compensated by the foreign licensor for any part thereof. The bright line concept is generally applied in cases of distributors and not entrepreneurial licensed manufacturers such as the taxpayer. Further, import of components from group company suppliers needs to be ideally bench marked in the hands of the foreign suppliers as tested parties, if such components are not embedded with significant intangibles. This approach would ideally be the situation in the majority of the cases where the licensees carry out significant localization.

COST PLUS METHOD (CPM): 

EXAMPLE

  • Company A has two units, one eligible and another non-eligible unit. Non-eligible unit (NEU) is engaged in the manufacture of electrical goods of varied range. One of such goods is heating element which it sells to the eligible unit (EU). EU is engaged in the manufacture of electrical heaters where it uses the heating element purchased from the NEU as a raw material.  NEU is not selling the heating element to any of its other customers. Few comparable companies are available which are engaged into selling similar products (electrical goods).  In the current scenario, Cost Plus becomes the most appropriate method wherein, the NEU charges EU a price which is calculated by adding a reasonable mark up the cost of production of such goods.

CASES:

  • L’Oreal India Pvt. Ltd., Mumbai vs Department Of Income Tax[7]

The assessee company was a subsidiary of L’Oreal SA France engaged in the business of manufacturing and distribution of cosmetics and beauty products (contract manufacturing). The TPO rejected CPM and adopted TNMM as the MAM and proposed an adjustment of Rs. 1.99 crores (approx) on its international transaction of purchase of raw materials. The CIT (A) order stated that “CPM is applied to test the price of goods that are manufactured and then sold or to measure the value of services performed by a service provider and is generally appropriate when the party being examined is not engaged in significant value adding activities”. Accordingly, the Tribunal upheld the categorical finding of the CIT(A) that the Cost Plus Method adopted by the assessee is based on the functions performed and not on the basis of types of product manufactured, as normally the pricing methods get precedence over profit methods.

  • Dishman Pharmaceuticals & Chemicals Ltd.[8]

The Tribunal held that given the facts of the case, use of internal CUP was not appropriate for benchmarking international transaction of exports to associated entities due to various differences. The Tribunal observed differences on account of (a) low volume, (b) sales within Indian market and (c) sales to different geographical location having incomparable economic and political risks. Relying on OECD guidelines, the Tribunal also upheld the contention that TNMM is not the method of last resort and accordingly allowed TNMM applied by the assessee.

  • ITO vs. Alumeca India Extrusion Ltd [9]

Taxpayer was engaged in manufacture of aluminium products. During the year under consideration, taxpayer made export sales to AEs and domestic sales to non-AEs. The taxpayer adopted Internal CPM to benchmark its international transactions. TPO rejected internal CPM adopted by the taxpayer alleging that allocation of costs to the AE and non-AE segments was incorrect. He thus adopted external TNMM and made transfer pricing adjustments.

  • Frigoglass India Pvt. Ltd. vs. DCIT[10]

Taxpayer (FIPL) is engaged in manufacturing and trading of glass door merchandising used in alcoholic and non-alcoholic beverages, water, dairy products etc. Taxpayer entered into various international transactions including sale of finished goods, sale of components & spares, purchase of raw materials, and purchase of finished goods for resale. Taxpayer benchmarked transactions in its manufacturing segment using cost plus method (CPM) and transactions in its trading segment using resale price method (RPM). TPO also rejected both these methods on account of various reasons and adopted entity level TNMM to benchmark transactions in both segments. ITAT observed that TNMM method applied by the TPO also suffers from the same inherent aberrations and thus taxpayer’s adoption and application of CPM and RPM need to be upheld.

  • GE BE Private Limited case[11]

The Bangalore Bench of the Income-Tax Appellate Tribunal in the case of GE BE Private Limited has adjudicated on the use of Cost-Plus Method (CPM) as the most appropriate method in the case of contract manufacturers.

RESALE PRICE METHOD (RPM):

EXAMPLES:

  • A Ltd is a distributor of IT products . A Ltd purchases desktops from its related party, P Ltd. A Ltd also trades in laptops manufactured by X Ltd. P Ltd as well as X Ltd would supply the warranty replacements free of costs to A Ltd.
  • A Ltd is a distributor of IT products. A Ltd purchases desktops from its related party, P Ltd. – A Ltd also trades in laptops manufactured by X Ltd. Only P Ltd would supply the warranty replacements free of costs to A Ltd; X Ltd would supply the product without providing warranty

 

CASE:

  • ITO vs. L’Oreal India P. Ltd[12]

The Tribunal upheld the use of Resale Price Method over TNMM where assessee bought products from AE and resold them without further processing; ITAT agreed with the CIT(A)’s observation that there is no order of priority of methods to determine ALP. ITAT noted that OECD Guidelines stated that in case of distribution and marketing activities, when the goods are purchased from AEs which are sold to unrelated parties, RPM is the most appropriate method.

PROFIT SPLIT METHOD (PSM): 

EXAMPLE:

“Company A” – Designs and manufactures a component

Transfers to B

 “Company B”– Designs and manufactures rest of the component

Transfers to C

 “Company C” – Distributes the component

MAP in this case would be CUP if similar comparable could be found Component transferred from A to B reflects innovativeq technological advance enjoyed by A in the market  Thus, may not be possible to find a reliable CUP to estimateq the correct ALP that A could command

CASE:

  • Infogain India Pvt. Ltd vs. DCIT[13]

The Tribunal had to consider whether the most appropriate method is the Profit Split Method (PSM) as claimed by the assessee or the TNMM as claimed by the AO, while working out the Arm’s length value in respect of international transactions between Infogain India i.e. assessee and Infogain US i.e. parent company. Both the OECD Transfer Pricing Guidelines as well as the UN draft method of transfer pricing for developing countries, suggest that an allocation of residual profits under PSM should be done, based on contributions by each entity. In the present case, since the department has accepted in the preceding year and the succeeding year 40:60 ratio between the Infogain India and Infogain US and if the facts are similar for the year under consideration then no deviation is to be done.

  • ITO vs. Net Freight (India) Pvt. Ltd[14]

Taxpayer was a logistics service provider offering a comprehensive portfolio of international, domestic and specialized freight handling services. Taxpayer along with its fellow subsidiaries mutually appointed each other as exclusive agents with respect to the transportation of shipment. Taxpayer and its AEs had an arrangement of sharing profit in the ratio of 50:50 for these services. Taxpayer adopted Residual PSM as the MAM to determine the ALP of the aforesaid international transactions. TPO rejected Residual PSM on the grounds that sufficient information was not available to determine appropriateness of the 50:50 profit sharing ratio. The TPO thus adopted entity level TNMM to benchmark the taxpayer’s international transactions. However, CIT(A) upheld the taxpayer’s plea and deleted the TP adjustment. ITAT explained the law on PSM, discussing transactions where PSM can be adopted as MAM, methodology of application of Residual PSM.  ITAT observed that though PSM was the MAM in the present case, the taxpayer didn’t apply Residual PSM correctly. The taxpayer did not allocate appropriate base returns to the respective entities as required under the first stage of PSM.

Global One India P. Ltd Vs ACIT[15]

Taxpayer is engaged in providing internet and related network services to the group’s customers in India. Taxpayer’s activities are highly integrated & interrelated where transaction passes through multiple AEs & each entity makes contribution by deploying its assets, performing functions & using manpower.  Accordingly, the taxpayer adopted Residual PSM as the MAM

TRANSACTIONAL NET MARGIN METHOD (TNMM): 

EXAMPLES:

back office management services and routine low-risk contract Research and Development (R&D)

CASES:

  • Dishman Pharmaceuticals & Chemicals Ltd.[16]

The Tribunal held that given the facts of the case, use of internal CUP was not appropriate for benchmarking international transaction of exports to associated entities due to various differences. The Tribunal observed differences on account of (a) low volume, (b) sales within Indian market and (c) sales to different geographical location having incomparable economic and political risks. Relying on OECD guidelines, the Tribunal also upheld the contention that TNMM is not the method of last resort and accordingly allowed TNMM applied by the assessee.

OTHER METHODS:

The other method evaluates the arm’s-length character of a controlled transaction by comparing the price charged in the controlled transaction to the price charged or would have been charged in a same or similar uncontrolled transaction in comparable circumstances.  Under this method, quotations, price list, data referred to in commercial negotiations, data points reflecting market trend and other evidences may be relied upon. One needs to mention the reason for accepting/ rejecting the method based on the functional analysis. Also, reasons for considering Internal or External comparable companies are required to be mentioned.

  • Tally Solutions Pvt. Ltd Versus Deputy Commissioner of Income-tax[17]

TPO is directed to recalculate the ALP keeping in view the specific directions of this Bench. In the absence of uncontrolled independent comparable companies the Excess Earning Method (EEM) is to be adopted by the TPO. In the present circumstance, EEM is reasonable. The  main reason for adopting EEM method that it is only an internal CUP method, wherein, it is seen what is the price for which the same product would have been sold by the assessee to an independent entity.

If there are mixed industries, the MAM would be determined by the

  • Nature and class of transaction

 

  • Functions, assets and risks undertaken assesses and other party

It further provides that where more than one arm’s-length price is determined by applying the most appropriate transfer pricing method, the arithmetic mean (average) of such prices shall be the arm’s-length price of the international transaction or specified domestic transactions.

For bifurcating the most appropriate method, the following measurement focus is used:

For price – CUP

For gross income – RPM, CPM

For profit – PSM

For TNMM – Operating income.[18]

CONCLUSION

The Income Tax Act, 1951 provides for various methods for calculation of the arm’s-length price of the international transaction or specified domestic transactions. One of the methods prescribed is considered to be the most suitable one, depending upon the circumstances and the nature of transaction (FAR, Data availability, etc.). The bifurcation on the basis of industry provides for different kinds of function each industry provides and accordingly helps allocate the most appropriate method for the transactions. No order of priority has been set for selection of methods. The taxpayers are bestowed with the option to choose the Most Appropriate Method. If none of the specified method seems most appropriate then any “other method” which takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts is applied.  Each year is a new and a separate year. Thus, different methods can be used in each year depending upon the conditions prescribed. In short, the principle of res-judicata is not applicable.

[1] Anonymous, transfer pricing, link: http://www.taxjustice.net/topics/corporate-tax/transfer-pricing/, last accessed on 23. 01. 2016 at 5:00 p.m

[2]Anonymous,India, link: http://www.pwc.com/gx/en/international-transfer-pricing/assets/india.pdf, last accessed on 23. 01. 2016 at 5:12 p.m

[3] Sanjay Kapadia, WIRC – Intensive Study Course on Transfer

Pricing, Link: file:///C:/Users/Pavilion/Downloads/TP%20ARTICLE.pdf, last accessed on 23. 01. 2016 at 6:00 p.m.

[4]CA Vishwanath Kane, Methods of determining ALP, link: http://ctconline.org/documents/all/16.2.13%20CA%20Vishwanath%20Kane%20Transfer%20Pricing%20Methods%20-%20Feb%202013.pdf, last accessed on 23. 01. 2016 at 07:32 p.m.

[5] 445 SOT 391

[6]  [2014]147ITD630(Delhi)

[7] 6745/M/2008

[8] 587/Ahd/2007

[9] 613 & 614/Hyd/2009

[10] MANU/ID/0226/2014

[11] MANU/IL/0127/2013

[12] 5423/Mum/2009

[13](2015)173TTJ(Delhi)385

[14] [2014] 30 ITR(T) 441 (Delhi – Trib.)

[15] [2014] 31 ITR(T) 722 (Delhi – Trib.)

[16] 587/Ahd/2007

[17] 12(4) – 2011 (9) TMI 196 – ITAT BANGALORE

[18] Sanjay Kapadia, WIRC – Intensive Study Course on Transfer Pricing, Link: file:///C:/Users/Pavilion/Downloads/TP%20ARTICLE.pdf, last accessed on 25. 01. 2016 at 2:30 A.M


AUTHOR

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Niharika singh, student of Chanakya National Law University.

 


Disclaimer ;  The views and opinions expressed in this article are those of the authors. All data and information provided on this site is for informational purposes only. sapaa.in makes no representations as to accuracy, completeness, correctness or validity of any information on this site and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. 


 

Disclaimer:  The views and opinions expressed in this article are those of the authors. All data and information provided on this site is for informational purposes only. sapaa.in makes no representations as to accuracy, completeness, correctness or validity of any information on this site and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use.