Berry Ratio- Transfer Pricing

I History:  
The ratio is named after Professor Charles Berry, the expert hired by the IRS in the 1979 DuPont case

II Basic  

The underlying assumption of  the Berry ratio is that there is a positive relationship between the level of operating expenses and the gross profit. The more operating expenses that a distributor incurs, the higher the level of gross profit that should be derived.

 Barry Ratio= Gross Profit/Operating expenses  

The markup imposed on operating expenses represents the only value added by the distributor’s function, excluding the cost of goods sold.  As spending can merely represent the value added by the distributor, the arm’s length remuneration should not be higher than the markup earned on operating expenses.  

III Function Asset & Risk Analysis  

The unrelated distributor may take more risks than the related entity performing similar functions. This is because the market, inventory and credit risks are, to a major extent, borne by the parent company. The related distributor acts on behalf of the parent company, which assumes the majority of the functions and risks. Having said this, it may also be that, in practice, the unrelated distributor bears more risks than the related distributors performing similar functions.    

IV Application of Barry Ratio  

 In principle, the Berry ratio reflects the low risk profile of a pure distribution function, as compared to that of other independent distributors.    The Berry ratio cannot be applied to an integrated distributor that performs different functions such as assembling or customizing, because the ratio will not be able to reflect the pure return on operating expenses.  

V Non-application  of   Berry Ratio for Manufacturers  

For manufacturing activities, it is often difficult to distinguish which expenses relate to which activities and in what proportions. Moreover, a manufacturer’s cost base normally consists not only of operating expenses but also the cost of goods sold. In this regard, a profitability measure based solely on reduced operating expenses does not seem to be the most reliable one. For manufacturing activities, in addition to a markup on costs, a check of the return on assets should also be performed.

 VI OECD view  

The OECD supports the possible use of the Berry ratio, which, as mentioned, is defined as the ratio of gross profit to operating expenses. Interest and extraneous income are generally excluded from the gross profit determination; depreciation and amortization may or may not be included in the operating expenses.  

Difficulty

One common difficulty in the determination of Berry ratio, according to the OECD, is that the Berry ratio is very sensitive to the classification of costs as operating expenses or not, and therefore can pose comparability issues.

Usefulness

A situation where the Berry ratio can prove useful, according to the OECD, is for intermediary activities where a taxpayer purchases goods from a related party and on-sells them to other related parties. In such cases, the resale price method may not be applicable, given the absence of uncontrolled sales, and a cost-plus method that would provide for a markup on the cost of goods sold might not be applicable either where the cost of goods sold consists of controlled purchases. By contrast, operating expenses in the case of an intermediary may be reasonably independent from transfer pricing considerations, unless they are materially affected by related-party costs such as head office charges, rental fees or royalties paid to a related party, so that a Berry ratio may be an appropriate indicator, subject to the comments above.

Australia transfer pricing

:

The Australian Government has released an Exposure Draft of proposed retrospective amendments that will implement the first stage of reforms to transfer pricing.

The Exposure Draft was released by the Government on 16 March 2012 and follows the announcement and release by the Government of a Consultation Paper on 1 November 2011.

Australia's transfer pricing rules were introduced in 1982 and are currently contained in Division 13 of the Income Tax Assessment Act 1936 and in various Articles in Australia's Tax Treaties. Broadly, they ensure that Australia receives an appropriate share of tax revenue from cross-border transactions entered into by taxpayers. Principally, these transactions are undertaken between members of multinational groups.

The transfer pricing rules have not been materially amended since their introduction some 30 years ago. Legislative reform to the rules provides increased certainty with respect to their application and increased harmonisation with international practice.

However, the proposal to amend the legislation retrospectively has been controversial. The Commissioner contends that he has always had the power to use Tax Treaties in transfer pricing disputes. Many have argued that Tax Treaties are entered into to avoid double taxation and do not empower the Commissioner to impose taxation where no taxing right exists under domestic law.

These proposed amendments put that debate to rest for income years commencing on or after 1 July 2004. In the Explanatory Memorandum to the Exposure Draft, the Government notes that it has always held the views confirmed in the proposed rules (ie. since the introduction of the transfer pricing rules in 1982), however, the amendments will apply from 2004 on the basis that the 2004 income year commenced immediately after the Parliament last demonstrated its intention that the law should operate in this way.

Submissions on the current Exposure Draft close on 13 April 2012.

Interaction between Australia's Treaty network and Australia's domestic transfer pricing rules

The Exposure Draft proposes to introduce new subdivision 815-A into the Income Tax Assessment Act 1997 and is intended to implement the first stage of the proposed amendments to Australia's transfer pricing rules.

The Exposure Draft is focused on the interaction between Australia's Treaty network and its domestic unilateral transfer pricing rules contained within Division 13. The Exposure Draft confirms that where a Tax Treaty applies, the Treaty will apply and operate independently of the domestic legislation.

The purpose of proposed subdivision 815-A is to make certain:

that the transfer pricing Articles in Australia's Treaties (broadly being the "Associated Enterprises Article" and the "Business Profits Article") can be applied and operate to provide assessment authority independently of Division 13, through explicit incorporation into the 1997 Act; and to require the arm's length principle to be interpreted as consistently as possible with relevant OECD guidance.

Transfer pricing benefit

The new rules introduce the concept of a "transfer pricing benefit", which can arise in two situations:

firstly, when an Australian resident taxpayer enters into a transaction with an "Associated Enterprise" (eg. a foreign related party) and the amount of profit that might have been expected to accrue to the entity has not so accrued; and secondly, when the amount of profit attributed to the Australian PE of a foreign resident under the Business Profits Article is less that the amount of profit that might have been expected to have been attributed in the relevant circumstances.

The amount of the "transfer pricing benefit" is the difference between the profits accrued (or attributed, as the case may be) and the profits that might have been expected to have accrued (or have been attributed) had the parties been operating independently of each other. In the case of the Australian PE of a foreign resident, the profits that might have been expected to have been attributed to the entity are determined by treating the Australian PE as a "distinct" and "separate" enterprise.

If the thin capitalisation rules contained within division 820 of the 1997 Act also apply to an entity in relation to an income year, there are additional proposed rules that will apply in determining an entity's "transfer pricing benefit" for the income year. The additional rules are intended to ensure that any adjustment made to a taxpayer's tax position under proposed subdivision 815-A is used to establish the arm's length cost of debt capital under the thin capitalisation rules. This is consistent with the current administrative approach set out in Taxation Ruling TR 2010/7.

Determinations by the Commissioner

In circumstances where a "transfer pricing benefit" has been identified, the proposed rules empower the Commissioner to make determinations to ensure the taxpayer's liability to tax appropriately reflects the transfer pricing benefit received. For example, a taxpayer's taxable income may be increased, or a tax loss or capital loss may be decreased, relative to what the taxpayer has returned.

Relevance of OECD Guidelines

In its Consultation Paper released in November 2011, the Government notes that practitioners, the ATO and Treaty partner administrators have "extensively" relied on the OECD Guidelines in applying and interpreting transfer pricing profit allocation rules in Australia. The Consultation Paper also notes that courts in Australia have not endorsed the use of the OECD Guidelines in this manner. In fact, the relevant standing these rules have had has never been certain in practice. The Consultation Paper itself notes that "a clear legal pathway for use of the Guidelines might also reduce the need for legal argument on this point in litigation".

Relevantly, the Exposure Draft includes a proposed rule that explicitly refers to the guidance that can be relied on and referred to in determining whether a "transfer pricing benefit" exists. For the 2012-13 income year and later income years, the guidance that can be relied on is:

the Model Tax Convention on Income and on Capital, published by the OECD on 22 July 2010; the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration, published by the OECD on 18 August 2010; and any other documents prescribed in the Regulations.

For income years prior to 2012-13 (but beginning on or after 1 July 2004), the relevant OECD guidance is the version of the abovementioned documents that were last published before the start of the relevant income year.

Other issues for possible reform

The Consultation Paper released in November noted a number of other issues for consultation within the overall transfer pricing review that were focused on harmonising Australia's domestic legislation with international transfer pricing developments. Some proposals are to amend the legislation to:

specifically refer to the various transfer pricing methodologies that may be relied on to demonstrate adherence to the arm's length principle and introduce a "most appropriate method" (this would be consistent with recent OECD guidance and practice). At present, a number of other jurisdictions have legislative rules that govern the use and application of the transfer pricing methodologies that may be relied on. In Australia, these are referred to in ATO Taxation Rulings; introduce a legislative requirement for transfer pricing documentation. Again, this requirement is set out in ATO Taxation Rulings and other administrative guidance; broaden the arm's length principle; introduce time limits for the amendment of assessments due to a transfer pricing adjustment.

The Government has yet to announce whether further Exposure Draft legislation dealing with these issues will be released following the period of stakeholder consultation.

Recent TP Case laws- Summary

Now a days, during transfer pricing assessment, the TPO are coming with unique ideas like valuation of intangibles, corporate guarantees, ratings provided by CRISIL etc. this all leads to corporate in a mysterious situation. Below are the summarized form of the latest judicial pronouncements on transfer pricing which will help corporate in better benchmarking of their international transactions with their foreign associate enterprises.
· Bangalore ITAT in the case of Tally Solutions decided that there is nothing in s.92CA that requires the AO to first form a “considered opinion” before making a reference to the TPO. It is sufficient if he forms a prima facie opinion that it is necessary and expedient to make such a reference. The making of the reference is a step in the collection of material for making the assessment and does not visit the assessee with civil consequences. There is a safeguard of seeking prior approval of the CIT. Moreover, by virtue of CBDT’s Instruction No.3 of 2003 dated 20.5.2003 it is mandatory for the AO to refer cases with aggregate value of international transactions more than Rs.5 crores to the TPO The argument that the “Excess Earning Method” adopted by the TPO is not a prescribed method is not acceptable. A sale of IPR is not a routine transaction involving regular purchase and sale. There are no comparables available. The “Excess Earning Method” is an established method of valuation which is upheld by the U.S Courts in the context of software products. The “Excess Earning Method” method supplements the CUP method and is used to arrive at the CUP price i.e. the price at which the assessee would have sold in an uncontrolled condition.

· In the case of CIT v Rakhra Technologies ( P) Ltd 243 CTR 505 it was held that in the absence of any perversity in the finding of the Tribunal in the selection of a different set of comparables for determination of ALP and re-computation of ratio of operating profit/total cost at 21.97% as against 35.26% adopted by TPO, no interference is warranted. The High court further upheld the decision of the Tribunal of allowing depreciation on administrative assets for determining the operating profits while computing the ALP. (A.Y.2005-06).

· In the case of Diageo India Pvt. Ltd v ACIT 47 SOT 252 it was decided that If one enterprise controls the decision making of the other or if the decision making of two or more enterprises are controlled by same person, these enterprises are required to be treated as ‘associated enterprises’. Though the expression used in the statute is ‘participation in control or management or capital’, essentially all these three ingredients refer to de facto control on decision making. The argument, based on Quark Systems 38 SOT 307 (SB), that exceptionally high and low profit making comparables are required to be excluded from the list of TNMM comparables is not acceptable. Merely because an assessee has made high profit or high loss is not sufficient ground for exclusion if there is no lack of functional comparability. While there is some merit in excluding comparables at the top end of the range and at the bottom end of the range as done in the US Transfer Pricing Regulations, this cannot be adopted as a practice in the absence of any provisions to this effect in the Indian TP regulations. (Benefit of +/- 5% adjustment as directed in UE Trade Corporation 44 SOT 457 to be given); The adjustment made by the TPO with regard to the advertisement expenditure incurred by the assessee was without jurisdiction because the AO had not made any reference on this issue to the TPO. As the reference to the TPO is transaction specific and not enterprise specific, the TPO Officer has no power to go into a matter which has not been referred to him by the AO. Even the CBDT Instructions are clear on this (3i Infotech Ltd 136 TTJ 641 followed)( A.Y.2006-07).

· The expression “shall” has been used in rule 10B (4) which makes it abundantly clear that only current year data of an uncontrolled transaction is to be used for the purpose of comparability while examining the international transactions with AE s , unless the case is covered by the proviso i.e. if the data of preceding two years reveals facts which could have an influence on the determination of transfer price. Assessee company being engaged in producing semiconductor integrated circuits is a complex product requiring skilled workforce. TPO was justified in treating it as high end service provider for the purpose of selection of comparables. The fact that the assessee’s role is only 2 to 3 percent of the overall operations performed by the group is not at all relevant for deciding whether it is high end performer or low end performer. Assessee having submitted a TP report every year by using different filters for selecting comparables are commensurate to the result declared by it . TPO was justified in rejecting the same and selecting new comparables by applying quantitative as well as qualitative filters. Tolerance band provided in the proviso to section 92C(2) is not to be construed as a standard deduction. If the arithmetic mean of comparables falls with in range of said tolerance band , no adjustment is required , if it exceeds then the ultimate adjustment is not required to be computed after reducing the arithmetic mean by 5 percent.(A.Ys 2003-04 , 2004-05, 2006-07). Refer, ST Microelectronics (P) Ltd v CIT 61 DTR 1.

· ITAT Delhi in the case of DCIT vs. Leroy Somer & Controls (India) (P) Ltd held that though no transfer pricing adjustment was made, the AO levied penalty u/s 271G of Rs. 22 lakhs (2% of the value of international transactions) on the ground that the assessee had not furnished the documents prescribed under Rule 10D r.w.s. 92D(3). This was deleted by the CIT (A).
Norway Court of Appeal held in the case of Dell Products vs. Tax East that the assessee, a company registered in the Netherlands but resident in Ireland for tax purposes appointed Dell AS, a Norwegian company, as its “commissionaire” for sales to customers in Norway. Dell AS entered into agreements in its own name and its acts (under the commission agreement and Commission Act) did not bind the principal. The assessee claimed that it was not taxable in Norway in respect of the products sold through Dell AS on the ground that Dell AS was not its “Dependent Agent Permanent Establishment” (DAPE) under Article 5(5) of the Norway-Ireland DTAA on the ground that (a) the agent had no authority to enter into contracts “in the name of the assessee” and legally bind the assessee and (b) the agent was not a “dependent” agent. However, the income-tax department took the view that Dell AS constituted a PE under Article 5(5) of the DTAA and that 60 percent of Dell Products’ net profit on sales in Norway was attributable to the PE. This was confirmed by the Oslo District Court.

· Delhi High Court in the case of Oracle India (P) Limited decided that payment of royalty by assessee company to its US based holding company is not hit by the provisions of section 92 in the absence of any comparable case on record to determine the ordinary profit in similar business and the price fixed has been accepted as ALP by the TPO. Payment of royalty being a business expenditure which is incurred wholly and exclusively for the purpose of business of the assessee ,it is to be allowed as business expenditure.(A.Y. 1999-2000 TO 2001-02)

· Mumbai Tribunal held the following in the case of Fulford India Limited : TPO having computed the ALP by applying CUP method as against TNMM adopted by the assessee and rejecting the objections raised by the assessee on the ground that all those objections were considered by the TPO in earlier years. The assessee having raised various submissions before the Tribunal which need verification at the level of the AO/TPO matter restored for fresh verification as per law.(A.Y. 2006-07).

· In the case of Siva Industries & Holdings Ltd Chennai tribunal held that in case of grant of loan by assessee to its foreign subsidiary in foreign currency out of its own funds . For determining ALP ,it is the international LIBOR rate that would apply and not the domestic prime lending rate , and assessee charging interest at a rate higher than the labor rate , no addition can be made on this count.(A.Y. 2006-07)

· The assessee, engaged in providing support and advisory services to BP group companies, entered into international transactions with its AEs pursuant to which it made payments for “business support services”. The assessee adopted the TNMM and claimed that the transactions were at ALP on the basis that its profit rate compared favourably with the comparables. In the list of comparables were two entities which had suffered a loss. There were also two other companies with high profit margin. The TPO excluded the loss making companies from the comparables on the ground that they were having a different “functional & product profile” as compared to the assessee. In appeal, the CIT (A) held that the loss making concerns could not be excluded. He also upheld the alternate argument that if the loss making companies were excluded, the high profit companies also had to be excluded. Refer BP Services India (P) Limited, Mumbai ITAT.

· The assessee, engaged in the business of manufacture and export of studded diamond and gold jewellery, imported & exported diamonds and exported jewellery to associated enterprises. For transfer pricing purposes, the ALP of the imported & exported diamonds was evaluated using the “Comparable Uncontrolled Price” (CUP) method while the exports of jewelry was evaluated using the “Cost Plus Method” (CPM). The TPO & AO rejected both methods on the ground that adequate material to support it was not available and instead adopted the TNMM and made an adjustment. On appeal, the CIT(A) upheld the adoption of CPM on the imports & exports of diamonds on the ground that total cost details were maintained and the average margin earned from AE transactions was higher than that earned from non AE transactions. However, he did not deal with the ALV on export of jewellery. On appeal by the department, HELD reversing the CIT(A). Refer, ACIT vs. Tara Ultimo Private Limited .

· In the case of CIT vs. Nestle India Limited 337 ITR 103 it was held that business expenditure disallowed for excessive or unreasonable payments for remuneration/royalty paid to subsidiaries for technical assistance . Finding that such assistance essential for business and that expenditure not excessive or unreasonable hence section 92 does not apply to royalty which is not part of regular business between resident and non-resident

· When assessee showed the price charged was with in 5 % variation of ALP, no addition was required to be made.( Asst Year 2006-07). Refer, Capgemini India ( P) Ltd v Addl CIT. 46 SOT 195 (Mumbai) (Trib).
· Delhi Tribunal held in the case of NIT Limited that In view of the fact that annual reports / data base extracts of three companies which were selected as comparable cases were not available earlier in the public domain and having regard to the fact that these documents are essential for determining ALP these additional evidences are admitted for consideration : TPO is directed to make a fresh transfer pricing order by taking in to account database of said companies now submitted and also to decide as to whether all the comparables selected by the assessee are proper comparables for the purpose of determining ALP after considering the relevant parameters.( Asst year 2005-06).

· Adjustment of 5 % is not applicable if a single price is determined by the assessee. Circular no 12 dated 23-8-2001 does not apply to the case under consideration as the price variation is more than 5 %. (Asst Year 2004-05). Refer, ADP (P) ltd v Dy CIT 57 DTR 310 ( Hyd) ( Trib).

· Mumbai Tribunal held in the case of Teva India (P) Ltd v Dy CIT 57 DTR 212 that Exact nature of the business needs to be taken in to consideration vis –a –vis the nature of business activity carried on by other parties so as to ascertain whether the said parties can be selected as comparable cases for transfer pricing analysis ; Four companies included by the assessee company , there was no justifiable reason to select the same as comparables; however , exclusion of companies showing supernormal profits as compared to other comparable is fully justified.( Asst Year 2004-05).

· Pune Tribunal held the following in the case of Bringtons Carpets Asia (P) Ltd v Dy CIT 57 DTR 121 assessee having cited six comparables, TPO /AO was not justified in rejecting the same and applying domestic transactions of the assessee when the AO/TPO has accepted said six external comparables in the subsequent assessment year and there is similarity of facts in both the years, further the assessee is entitled to economic adjustments in the circumstances of under capacity utilization of the company, matter is set a side for examining the issue de novo. (Asst Year 2006-07)

· Each transaction of sale made by the assessee to its AE in UK being a separate transaction and there being no subsisting agreement between the assessee and the AE from beginning in 1996 , proviso to rule 10(4) is not applicable to the facts of the case and therefore , assessee was required to maintain documents as per rule 10D . Cases relied upon by the TPO not being comparable cases, matter is restored to the AO to obtain data of comparable cases so as to come to an informed decision as to whether the price charged by the assessee from its AE is arm’s length or not.(A.Y. 2006-07 ). Refer Delhi Tribunal decision in the case of Airtech (P) Ltd v Dy CIT 57 DTR 169.

· Mumbai ITAT in the case of RBS Equities India Ltd decided that the assessee adopted the TNMM to determine the ALP in respect of the broking transactions entered into with its affiliates. The AO & TPO held that the assessee ought to have adopted the CUP method and made an adjustment of Rs. 1.10 crores. This was accepted by the assessee. The AO levied penalty under Explanation 1 to s. 271(1)(c) on the ground that the assessee had filed inaccurate particulars of income. This was deleted by the CIT (A).

· Without ascertaining the quality and size of precious stones as sold to Associated Enterprise as compared to other enterprises, the Assessing Officer could not have made any adjustment on account of quality, and therefore, the addition made by Assessing officer on account of ALP was liable to be deleted.(Assst Year 2005-56). Refer, ITO v Kanchan Tara Exports 138 TTJ 592 (JP) (Trib).

· While determining arm’s length price, it is profit as per books of account that has to be considered for computing net margin of assessee and not adjusted book profits. ( Asst Year 2006-07). Refer, Geodis Overseas (P) Ltd v Dy CIT 45 SOT 375 (Delhi )(Trib).

· The AO had accepted the license fees for the month of February and March , 2003 to be at arm’s length . However the steep increase given from the beginning of the year with retrospective effect has not been accepted .CIT (A) has accepted the computation made by the assessee, based on the comparable as well as department has accepted the method of computation for the asst year 2004-05. The Tribunal restored the matter to the file of AO for re working of the transfer pricing adjustments using TNMM on the basis of facts and figures available for asst year 2003â€04 in respect of the comparable selected by the assessee.( Asst Year 2003-04). Refer, Asst CIT v NCG Net work (India ) (P ) Ltd 56 DTR 1 (Mumbai) (Trib).

· Provision for import duty made by the assessee which has been reversed in the immediately succeeding year being merely a book entry , is to be excluded for working out the operating profit ratio for computation of ALP (Asst year 2005-06 & 2006-07). Refer, Sony India (P) Ltd v Addl CIT 56 DTR 156 ( Delhi) (Trib).

· Transfer Pricing Officer having excluded the loss making companies from the list of comparables in the transfer pricing analysis , one company which showed the super profits is also to be excluded as it is engaged in software product company. Where as the assessee is engaged in rendering soft ware development services in OP/TC of the assessee is with the safe harbor range of + 5 percent , no adjustment is warranted on account of difference in ALP of the international transaction. (Asst Year 2006-07). Refer, Sapient Corporation ( P) Ltd v Dy CIT 56 DTR 465 ( Delhi ) (Trib).

· ITAT Delhi held the following in the case of Yum Restaurants(India) Pvt. Ltd From the list of comparables provided by the assessee (after excluding persistent loss-making companies), the TPO rejected some other loss-making companies & determined the ALP applying the TNMM and made an adjustment of Rs. 2.28 crores. The Tribunal dismissing the appeal held that : Merely because a company is showing losses, it does not lose its status of comparable if the other criteria depict its status as a comparable because the declaration of loss is an incident of business which is at par with profit. The FAR Analysis of a company indicated the avowed objective of the company and the tools that it sought to employ to achieve that objective but it was the financial result which decided whether that company has been successfully in achieving the objective or not. The TPO held that if the assessee’s contention based on FAR analysis only is accepted then the process of choosing comparable will not proceed beyond the matching of FAR. All types of other tests i.e. data base screening, quality and quantitative screening or use of diagnostic with ratios will be rendered meaningless and unnecessary. Comparability has been taken into consideration by the assessee on the basis of FAR analysis and “other aspects” have not been considered. TPO had looked into “other aspects” also.

· ITAT Hyderabad decided the following in the case of Deloitte Consulting India Pvt. Limited The Tribunal had to consider two Transfer Pricing issues (i) whether notional interest relatable to the extended credit period allowed to the Associated Enterprises (AEs) to pay the dues can be assessed and (ii) Whether, in the absence of any agreement between the assessee and the AEs to share costs, the consultancy expenses paid to McKinsey & Co can be disallowed on the ground that it benefited the AEs as well.

· ITAT Pune in the case of Patni Computer Systems Ltd held that The Tribunal had to consider two Transfer Pricing issues (i) whether notional interest relatable to the extended credit period allowed to the Associated Enterprises (AEs) to pay the dues can be assessed and (ii) Whether, in the absence of any agreement between the assessee and the AEs to share costs, the consultancy expenses paid to McKinsey & Co can be disallowed on the ground that it benefited the AEs as well.

· In respect of AY 2006-07, the assessee entered into international transaction with its associate enterprises for a sum of Rs. 14.33 crores. The TPO applied the TNMM and determined the ALP at Rs. 15.08 crores and made an adjustment of Rs. 75 lakhs. The assessee claimed that as the said adjustment was within +/-5% of the ALP, no adjustment could be made under the proviso to s. 92C(2) as it stood pre-amendment by the F (No. 2) Act, 2009. The Department relied on Circular No.F.142/13/2010-SO (TPL) dated 30.9.2010 (Corrigendum) where the view was expressed that as the amendment came into effect from 1.10.2009, it would apply in relation to all cases in which proceedings are pending before the Transfer Pricing Officer on or after such date. HELD disagreeing with the Department’s contention. Refer, iPolicy Network Pvt Ltd vs. ITO (Delhi ITAT).

· A continuing debit balance in the account of the Associated Enterprise by itself does not amount to an international transaction under section 92B in respect of which arm’s length price adjustment can be made. Even assuming that the continuing debit balances of AEs can be treated as “International Transactions” the right course of applying the CUP method would have been by comparing this not charging of interest with other cases in which other enterprises have charged the interest , in respect of over dues in respect of similar business transactions, with independent enterprises. As no exercise has been carried out addition was deleted.( Asst year 2004-05). Refer, Nimbus Communications 43 SOT 695/ 55.

· The Tribunal had to consider the following transfer pricing issues: (i) Whether if two distinct services are rendered to the AE and mark-up is received for one and not for the other, the aggregate position can be considered for determining ALP, (ii) whether multi-year data can be considered, (iii) whether if loss making comparables are rejected, high profit making comparables should also be rejected? HELD by the Tribunal. Refer, Exxon Mobil Company India Pvt Ltd vs. DCIT (Mumbai ITAT).

· The assessee’s appeal raised the issues whether (i) the TPO could consider financial information of comparables not available at the time of TP study, (ii) multi-year data of comparables could be considered, (iii) a turnover filter had to be applied for identification of comparable companies, (iv) an adjustment for difference in functional and risk profile of comparable companies vis-à-vis of the assessee had to be made and (v) the amendment of +/-5% variation law was retrospective. HELD by the Tribunal: Refer, Symantec software Solutions Pvt Ltd vs. ACIT, Mumbai ITAT.

· ITAT Delhi held the following in the case of Sapient Corporation Pvt. Ltd. When loss making companies have been taken out from the list of comparables by the TPO, Zenith Infotech Ltd. which showed super profits should also be excluded. The fact that assessee has himself included in the list of comparables initially, cannot act as estoppel, particularly in light of the fact that the Assessing Officer had only chosen the companies which are showing profits and had rejected the other companies which showed loss (Quark System vs. Dy. CIT 38 SOT 307 (SB) followed). (A. Y. 2006-07)

· ITAT Mumbai held the following in the case of DHL Express (India) Pvt. Ltd. (i) The assessee’s argument that comparables with a turnover less than 20% of the assessee’s turnover should be considered is not acceptable because it is a universal fact that there are lot of differences between large businesses and small businesses operating in the same field. In the case of small business, economies of scale are not available and they are generally less profitable. The fact that such companies were considered comparable in an earlier year is not conclusive for want of facts of that year and also because there is no res judicata; (ii) The argument that segmental results of a company engaged in diverse activities should be considered is also not acceptable because it is a common experience that in many such results certain expenditures, particularly relating to interest and head office, are generally not allocated. When direct comparables are available, there is no need to consider segmented results; (iii) In principle, should be only the operating profit of the comparables considered. Items like interest income, rent, dividend, penalty collected, rent deposits returned back, foreign exchange fluctuations and profit on sale of assets do not form part of the operational income because these items have nothing to do with the main operations of the assessee. Insurance charges would depend on the nature of insurance charges. If the insurance charges were on account of loss of some parcel or courier against which courier has made a payment of compensation then such charges would constitute operational income. (A. Y. 2006-07). See Also Adobe Systems India (ITAT Delhi) (super-normal profit companies to be excluded) & Marubeni India (ITAT Delhi) (interest on surplus & abnormal costs to be excluded).

· On a reference under section 92CA(1), TPO can suggest adjustment only in respect of the international transactions entered in to by the assessee with AEs which are referred to him for computation of ALP by the Assessing Officer. TPO cannot suo motu take cognizance of any other international transaction for suggesting adjustment in the ALP. (A. Y. 2006-07). Refer, Amadeus India (P) Ltd. vs. ACIT 52 DTR 378 (Delhi)(Trib.).

· Assessee engaged in business of import of rough diamonds and selling same in local markets without value addition to goods, resale price method is most appropriate method for determining ALP with respect to AE transaction. If comparables cited by assessee were not found appropriate, fresh comparables could be searched, but method adopted was not to be rejected. Matter was set aside to Assessing Officer for disposal afresh after finding appropriate comparable and adopting resale price method. (A. Y. 2004-05). Refer, Star Diamond Group vs. Dy. CIT 44 SOT 532 (Mum.)(Trib.).

· Delhi ITAT in the case of Honda Siel Cars India Ltd. vs. ACIT 129 ITD 200 decided that TPO is not concerned, nor is he competent to decide as to whether the payment under collaboration agreement was capital or revenue and on the facts and circumstances, reference to the TPO for determining 'arm's length price' may not be necessary.

· Transfer Pricing principles on use of multi-year data, adjustment to operating profits & +/- 5% adjustment : The assessee adopted the TNMM and claimed that (i) as its operations were for a part of the year, an adjustment to the margins on account of ‘capacity utilisation’ should be made, (ii) the pre-operative expenditure should be excluded, (iii) multi-year data should be used to determine comparables, (iv) if only one comparable is left, the entire exercise should be carried out afresh and (v) even if there was only one comparable, the +/- 5% adjustment should be made. The AO & DRP rejected the claim. On appeal to the Tribunal, HELD. Refer, Haworth (India) Pvt Ltd vs. DCIT.
· Net Profit margin actually realised can only be taken as comparable when TNMM method is adopted for TP analysis. Refer, Geodis Oversweas Limited v DCIT 10 Taxmann.com 231.
· Merely because transaction is with AE can't be ground to reject it as a comparable when transaction is at arm's length. Refer, ACIT v NGC Network India (P) Limited 10 Taxmann.com 140.
· Sec 92C(2) specifies that adjustment of 5 percent is not applicable if a single price is determinded by assessee. Refer, ADP Private Limited v DCIT. 10 Taxmann.com 160.
· Inclusion of non-operating income and non - exclusion of the non -operating expenses would definitely affect net margin of operating profits of comparable company. Refer, TNT India (P) Limited v ACIT, 10 Taxmann.com 161.

· Where the finding of CIT(A) is based on net profit margin of the assessee company worked out by him at 6.97% on the basis of operating profits/sales, which was within +/- 5 % range of ALP, there is no reason to interfere in the order of CIT(A). refer, Osram India (P) Ltd. vs. Dy. CIT 51 DTR 297 (Delhi) (Trib.).

· Though the deputation of three employees by the assessee to its US subsidiary without consideration is covered by the definition of “international transaction” under section 92B (1), it was not necessary for the Assessing Officer to determine the ALP of the said transaction as there would be erosion of tax base of India if the assessee charges the cost of deputation of employees in as much as assessee is remunerating the subsidiary on the cost–plus basis for the services and entire revenue accrues to the assessee. Jurisdiction of TPO is restricted to the transactions referred by the Assessing Officer under section 92CA(1) and therefore, TPO cannot determine the ALP in relation to an international transaction not referred to him by the Assessing Officer under section 92CA(1), further, since the conditions laid down in section 92C(3) were not satisfied the impugned addition cannot also be sustained on the premise that the Assessing Officer as determined the ALP on the basis of material or information or document in his possession. Refer, 3i Infotech Ltd. vs. Dy. CIT, 51 DTR 385 / 136 TTJ 641/ 129 ITD 422 (Mum (Trib.).

· Bad debts written off cannot be factor to determine the arm’s length price of any international transaction. The Transfer Pricing Officer had exceeded his limits in following a method not authorized under the Act or Rules. Refer, C. A. Computer Associates P. Ltd. vs. Dy. CIT 8 ITR 142 (Mum.)(Trib.).

· Order was passed by TPO without granting extension of time sought by the petitioner for furnishing more documents and giving an opportunity of personal hearing to it and also documents were not consider which were already on record in their right perspective the impugned order was set aside and TPO was directed to pass an order and also personnel hearing.. refer, Toyota Kirloskar Motor (P) Ltd. vs. Addl. CIT 52 DTR 393 (Kar.)(High Court).

Transfer Pricing: The game changer

Transfer pricing: The game changer


Samir Gandhi and Manisha Gupta, March 26, 2012



To reduce litigation and to expand the scope of tax , the Centre has brought about many changes in the Budget



The Finance Minister presented the Finance Bill 2012 in the Parliament on March 16, 2012 proposing significant amendments in the transfer pricing regulations. Transfer Pricing regulations in India are presently applicable only to cross-border transactions. However, the budget has now proposed to extend the transfer pricing regulations to domestic transactions as well, if the aggregate value of transaction exceeds Rs 5 crore. This move is expected to further increase need for tax compliance in India.



In recent years taxpayers in India have been confronted with large scale litigation in transfer pricing. Latest estimates from press reports on the recently completed assessment suggest that the tax authorities have demanded to the tune of Rs 45,000 crore from foreign MNCs in India which was further compounded by conflicting judicial rulings.



The silver lining in the budget is the introduction of APA (Advanced Pricing Agreements) which is expected to provide certainty. An APA is an arrangement between the tax payer and the tax authority made prior to actual transactions, with a view to solve potential taxation disputes in a mutually agreed manner. The objective of an APA is to deliver certainty, for both the taxpayer and the tax authorities, of the tax outcomes of the taxpayer’s international transactions. Consequently, APAs provide a win-win situation for all the parties involved. The APA will be binding on both parties and would be valid for a maximum period of five years. The detailed rules and procedures would be notified by the Board.



The extension of transfer pricing regulations will now include certain domestic transactions. The Supreme Court in the case of CIT Vs Glaxo SmithKline Asia (P) Ltd has suggested that Ministry of Finance should consider appropriate provision to make Transfer Pricing regulations applicable to certain related party domestic transactions. The tax law, as it stands today, empowers the tax office to disallow unreasonable expenditure incurred among domestic group companies (or expressed as related party transactions) and empowers tax department to re-compute the income of a tax payer eligible for certain tax incentives based on fair market value. However, the law does not provide any method to determine reasonableness of expenditure or fair market value to re-compute the income of such transactions.



Budget 2012 proposes to extend the applicability of Transfer Pricing provisions to the above domestic transactions. For example, under the proposed amendments the transfer pricing officer will also examine payments made to directors and computation of income and allocation of expenses between related party undertakings claiming tax holiday. Whilst on one hand the proposals increases the compliance burden of the tax payer and, on the other, tax authorities do not allow the tax payer to obtain certainty as the tax payer is not entitled for APA on domestic transactions.



Transfer Pricing regulations are applicable to specified cross-border transactions referred to as “international transaction”. There has been some controversy on whether the definition of international transaction covers certain unique transactions pertaining to intangibles, business restructuring etc. Further, recent judicial decisions have held that Transfer Pricing regulations do not apply to transactions which are not specifically covered under the definition of international transactions as provided in the income tax law.

Therefore to provide clarity, the budget 2012 proposes to specifically widen the definition to include business restructurings, corporate guarantee and other financial transactions, advance, deferred payment and receivables, provision of marketing research, marketing development and other services. The definition has also widened the scope of intangible property to include transfer of ownership, trademark, rights, brands, customer lists, commercial secret, franchises, design etc. This amendment is proposed to be made retrospectively effective from the date of introduction of transfer pricing laws in India from April 1, 2001. In view of the ongoing transfer pricing litigation, the government in the Finance Act (No 2) 2009 had introduced an alternate dispute resolution mechanism to deal with transfer pricing disputes whereby a collegium of three commissioners of income tax was constituted for speedy resolution of disputes. However, the DRP did not meet its stated objectives and has not been very effective. One of the possible reasons commonly considered for this was that the directions of the DRP were binding on tax authorities and they could not appeal to the tribunal against any unfavourable decision. However, the taxpayer on the other hand could appeal to the tribunal against any unfavourable decision.



Budget 2012 has proposed to do away with this limitation and now allows the tax authority to file a further appeal with the tribunal thereby creating a level playing field for tax authority and tax payer.



The amendments proposed by Budget 2012 are a mixed bag for the tax payers. On one hand the regulation has been widened in definition and coverage of domestic related transactions but on the other hand the Budget 2012 has proposed to introduce APA which could be a game changer if implemented in the right manner.

The TP Bomb! 24 Mar 2012, 12:18 PM

Before the arrival of GAAR, TP topped the list of acronyms most hated by companies. TP or Transfer Pricing regulations were till now applicable only on international transactions between associated enterprises. But this Budget Finance Minister Pranab Mukherjee announced that transfer pricing regulations will apply to domestic transactions of Rs 5 crore and more in value. This is another litigation minefield. Last year international transfer pricing adjustments amounted to Rs 50,000 rupees, equal to the total adjustments made over 6 previous years. So how can Indian companies avoid spending all their profits in court? Sanjay Tolia of PwC and S Gayathri of Essar hopefully have that answer!

Doshi: You described to me the bulk of the transactions that would come under transfer pricing now with the imposition of this new rule and you said in the case of excessive cost i.e. company X pays three times the market rent to an associate company in order to overstate cost and reduce taxable profits - that would now come under transfer price regulations or in the case of more than ordinary profits as you described it whereas company X under-prices raw materials sold to an associate company while thats located in an SEZ so that the profits are transferred to the exempt company- that would be another description of the kind of transactions that would come under transfer pricing regulations now. Have I, with these two descriptions, covered the universe of transactions or are there others that you think will also get impacted?

Tolia: I think it covers almost 90% of the universe and one of the interesting additions which comes to this transaction is going to be managerial remuneration of directors and I am not sure how one would benchmark that and I think time will show that how one could support that.

Doshi: Can you describe to the situation?

Tolia: You have the provision which is talking about the excessive expenditure where the related party, the associate person, also includes managing directors and relatives of directors etc and one has to provide data around what is the remuneration paid to them. Now that this particular transaction gets covered under the domestic transfer pricing rules, it will require the same certification and the documentation and when you get into those documentation exercises, you need to benchmark that -what you are paying to your managing director is at arms length. I am not sure how is one going to compare the companys managing directors remuneration with any other company. So this is going to be a challenge and I dont think that was the intention.

Gayathri: All of these transactions which have an inherent expenditure in them- purchases, services, rent, royalties, technical services, cost sharing arrangements - these are some of the expenses that would be subject to transfer pricing scrutiny.

Doshi: This was already under tax scrutiny to begin with, right, they were always meant to be carried out to what you all call fair market value or maybe even arms length pricing. So what has changed by the imposition of transfer pricing regulations on these?

Gayathri: The very essential difference is that fair market value is something that was not defined it was subject to interpretation and you could just have one particular value and say this is fair market value as against the transfer pricing legislation which would involve methodical benchmarking system based on prescribed methodologies.

Doshi: So it is, in fact, an improvement that we are now moving away from what was a discretionary undefined situation to a situation that is better defined; if not tightly defined?

Gayathri: I do think the intension is well- for one; it would bring out better governance, discipline and even clarity. The only point is it makes me nostalgic and I remember when TP or even the FTP provisions first came in, we imported a host of provisions and then added our own set of very punitive and
Gayathri: I do think the intension is well- for one; it would bring out better governance, discipline and even clarity. The only point is it makes me nostalgic and I remember when TP or even the FTP provisions first came in, we imported a host of provisions and then added our own set of very punitive and onerous.(Interrupted)

Doshi: So what in this, do you think, would fit your description of our own set of very punitive or onerous rules?

Gayathri: Quite obviously there is precedence for domestic transfer pricing in other countries in the world for e.g. US, UK, China, Indonesia, Netherlands, but if you look at the rules in all of these countries there is somewhere a kind of provision to make these applicable or bring these under scrutiny only where there is a perceptible risk. In other words, cases where clearly the tax rates are the same and there is no erosion or where there are no losses really or they seem to be operating at arms length or whether purely domestic transactions- these are cases which are exempted. We dont have something like that here yet.

Doshi: Are you suggesting that this would have been better accepted if they had crafted separate rules for domestic transfer pricing as opposed to the rules that are imposed on international transfer pricing?

Tolia: Maybe we can take one example - most of the countries have interquartile range which is defined as arms length price. In India, we have very strict regime which is an arithmetic mean of comparables. So you need to take an average of comparables and then you add a very small tolerance limit which was up to 5%, which is now reduced to 3%. Given that type of a scenario and thats one of the reasons we have had so many adjustments and you just spoke about the adjustments which is around Rs 50,000 crore - in that particular regime bringing the same provisions for domestic transfer pricing and specially for companies which are having tax holiday, now companies which are having tax holiday, they cannot exactly meet the average margin, there could be a little more than the average margin. So I think if there was a space provided there, different rules- right, you can have same documentation rules, you can have the same certification rules but at least a definition of the arms length price would Mar 2012, 12:18 PM

have become a range, it could have been better for the tax holiday units because otherwise I think there could be a good amount of litigation around this particular area.

Doshi: What are some of the other challenges that you see companies having to face?

Gayathri: There is a normal principle of relying on previous assessment for e.g. if you have domestic specified transactions of about Rs 4.75 crore this year you are assessed by the assessing officer and he applies fair market value system or the parameter and the next day, for no other reason, except maybe inflation, I have Rs 5.15 crore international transaction and I am going to be assessed by the transfer pricing officer using those prescribed methodologies- I mean there is no way one can rely on the previous assessment order and then if your transactions kind of hover around that figure, you could just have a flip-flop.

Doshi: The other thing I came across was and maybe this is not relevant but I will ask nonetheless that they have widened the meaning of related persons to include fellow related parties where a single person has substantial interest in two companies. What does that mean, what impact will it have?

Tolia: In the existing transfer pricing provisions, which were for cross border, you had sister concerns also covered. So if there is single parent which is holding two subsidiaries in India for e.g. the two subsidiaries in India would become related parties but under the existing provisions which we had for the domestic transfer pricing, only the holding subsidiary companies were covered. The sister concerns were not covered. So by expanding this definition, the sister concerns also get covered.

Doshi: So in domestic TP, will sister companies also get covered?

Tolia: Now it will get covered.

Doshi: And what is the threshold to define associated entities or how do you determine who is an associate entity?

Tolia: Thats a very interesting question. In the international transfer pricing you have a threshold of 26% -so if you are holding directly or indirectly 26% or more voting power in the other company, you become related. In the 40(A) provision which is relating to excessive expenditure, the definition is about substantial interest- so if one has a substantial interest in the other entity and that is defined as more than 20% and if you look at the tax holiday units, in the tax holiday units there is no threshold, the words used are close connection. This makes the compliance of these rules very difficult. It would be good if, while these changes were coming into play, the definition would have harmonized for all the three perspectives so that one would have been able to apply the same principles.

Gayathri: This just means that its going to make it interesting - so if it is above 26, its the prescribed method, if its less than 26%, then fair market value. I think it would be safe in saying fair market value as per the prescribed methods.

Tolia: If close connection is applied, I dont know what definition the tax officers are going to apply because even if one has to comply with that. (Interrupted)

Doshi: International transactions have been expanded to include the whole variety of intangibles, marketing intangibles, corporate guarantees and all of that starting this budget- will that also extend to domestic transfer pricing?

Tolia: Ideally, they would not get covered under the domestic transfer pricing- thats my view but if there is expenditure or if there is expense on the books of a particular company on account of corporate guarantee or on account of marketing intangibles, then they will have to demonstrate that that is an arms length price. If it is not there in the books of accounts, if there is no payment made for this particular transaction, they may not need to defend it because (Interrupted)

Doshi: But if there is no payment made, then the point you were making is the case of no payment 4 Mar 2012, 12:18 PM

made- thats what came under scrutiny in international transfer pricing.

Tolia: Yes.

Gayathri: Which brings one back to whether there should be any difference between cross border transaction and in domestic.

Doshi: One more challenge that you brought up to me offline and I want you to articulate on air and that is the fact that there could be cases of double taxation that come into this if I was putting it simplistically and that is that if you had an issue or case of excessive cost, then you would get identified on one end of the transaction whereas that would not get nullified on the other end of the transaction. Have I understood that correctly?

Gayathri: Yes.

Doshi: So that is going to be another big challenge to deal with?

Gayathri: Yes.

Doshi: How do companies anywhere else in the world navigate through something like this?

Gayathri: I am aware that in UK at least they do have mechanism for set off in case of adjustment in one UK company. 24 Mar 2012, 12:18 PM

Tolia: I think international transfer pricing regulations have provisions in the treaty. So if there is an adjustment on one side of the country, the other side based on the treaty provisions should provide and that happens through mutual agreement procedure between the two competent authorities but we dont have anything for the domestic transactions.

Doshi: How do you prepare as a company for the onslaught of TP on domestic transactions?

Gayathri: This is going to be tough- mapping out all your transactions, looking at them very differently and looking at regulations and see how you can put them all together, reams of paper, good for the paper manufacturing companies.

Transfer Pricing -changes in unioun budget

1. APA introduced (with effect from 1st July 2012)

2.Extention of TP to certain domestic transaction( with effect from 1st July 2012.)

3.Clarification on definition of international transaction

4. ALP range as per Section 92C(2) of the Act- to be applied retrospectively and range cannot exceed 3% from FY 12-13

5.Reference to TPO- TPO can adjudicate any thransaction which was not reported in form 3CEB.