TRANSFER PRICING

Transfer pricing refers to the setting, analysis, documentation, and adjustment of charges made between related parties for goods, services, or use of property (including intangible property). Transfer prices among components of an enterprise may be used to reflect allocation of resources among such components, or for other purposes. OECD Transfer Pricing Guidelines state, “Transfer prices are significant for both taxpayers and tax administrations because they determine in large part the income and expenses, and therefore taxable profits, of associated enterprises in different tax jurisdictions.”

Many governments have adopted transfer pricing rules that apply in determining or adjusting income taxes of domestic and multinational taxpayers. The OECD has adopted guidelines followed, in
whole or in part, by many of its member countries in adopting rules. United States and Canadian rules are similar in many respects to OECD guidelines, with certain points of material difference. A few countries follow rules that are materially different overall.

The rules of nearly all countries permit related parties to set prices in any manner, but permit the tax authorities to adjust those prices where the prices charged are outside an arm's length range. Rules are generally provided for determining what constitutes such arm's length prices, and how any analysis should proceed. Prices actually charged are compared to prices or measures of profitability for unrelated transactions and parties. The rules generally require that market level, functions, risks, and terms of sale of unrelated party transactions or activities be reasonably comparable to such items with respect to the related party transactions or profitability being tested.

Most systems allow use of multiple methods, where appropriate and supported by reliable data, to test related party prices. Among the commonly used methods are comparable uncontrolled prices, cost plus, resale price or markup, and profitability based methods. Many systems differentiate methods of testing goods from those for services or use of property due to inherent differences in business aspects of such broad types of transactions. Some systems provide mechanisms for sharing or allocation of costs of acquiring assets (including intangible assets) among related parties in a manner designed to reduce tax controversy.

Most tax treaties and many tax systems provide mechanisms for resolving disputes among taxpayers and governments in a manner designed to reduce the potential for double taxation. Many systems also permit advance agreement between taxpayers and one or more governments regarding mechanisms for setting related party prices.

Many systems impose penalties where the tax authority has adjusted related party prices. Some tax systems provide that taxpayers may avoid such penalties by preparing documentation in advance regarding prices charged between the taxpayer and related parties. Some systems require that such documentation be prepared in advance in all cases.

Transfer pricing , 31 May 2011

• — Arm’s length Price — Even if there was only one comparable, +/- 5% adjustment should be made. In determining ALP only companies which are functionally comparable are to be considered — as held by DelTrib in Haworth (India) Pvt. Ltd. v DCIT — In favour of: The Assessee (Partly) ; ITA No. 5341/Del/2010 : Assessment Year: 2006–2007
• Only the current year’s financial data is relevant for the determination of ALP except where it is shown that the data of the earlier two years reveals facts which could have an influence on the determination of the transfer price.
• Depreciation — Printers and UPS are eligible for depreciation at 16%
• The assessee, a wholly owned subsidiary of Haworth Inc., engaged in the business of manufacturing, wholesale trading and installation of Haworth branded furniture using raw material imported from its associated enterprises (“the AEs”). It also provides marketing and related support services to “Haworth”, Singapore. During the relevant assessment year, in order to benchmark the international transactions, two segments have been created by the assessee namely: (1) import of raw material for manufacturing and (2) marketing support services. For the manufacturing segment, TNMM was adopted as the most appropriate method with OP/Sales as a Profit Level Indicator (PLI) and the assessee has computed a net profit margin of 13.50% in its TP study as against the mean margin of five comparables at 9.17%, and the transaction was considered as at an arm’s length price. For marketing support services segment also, TNMM was adopted as the most appropriate method with operating profit on costs (“OP/TC”) as the relevant PLI. The taxpayer’s PLI was computed at 1.35% as against comparables’ PLI of 3.15%. For this segment the margin of comparable data for multiple years has been used in the TP report. The transactions were inferred to meet the arm’s length principle by the application of +/- 5% range permitted in law.
• During the course of the assessment proceedings, the TPO observed that for the manufacturing segment, the assessee computed its margin after claiming an adjustment on account of capacity utilisation and preoperative expenses and the assessee has based its calculation of margin which varied from the audited annual accounts. The TPO rejected the claim of the assessee regarding the adjustments to be granted to the assessee on account of capacity utilisation and preoperative expenses. The TPO further observed that the statutory auditors have not considered any expenditure as preoperative expenditure and the claim of preoperative expenses was made only for the purpose of Transfer Pricing. In the transfer pricing report no evidence were available to examine the capacity utilisation of the comparables. For the manufacturing segment, it is noticed by the TPO that as per the revised return filed for the year under consideration, the earlier margin computed at 1.13% was revised and recomputed at 9.63% by taking into consideration the disallowed expenditures. However, the TPO did not permit such recomputation and considered such disallowed expenses as operating cost. Further, three comparable companies were rejected due to the non-availability of current-year data and one more comparable, Alfred Herbert India Limited (“Alfred Herbert”), was excluded on account of functional dissimilarity and non-availability of segmental information.
• The TPO has rejected the claim of the assessee regarding the grant of 5% adjustment on the ground that the difference in arm’s length price exceeded 5 and upward adjustment was made to the total income of the assessee. The dispute resolution panel rejected the assessee’s appeal. Being aggrieved, the assessee has filed the present appeal. The assessee contended that as its operations were for a part of the year, an adjustment to the margins on account of “capacity utilisation” should be made, the pre-operative expenditure should be excluded, multi-year data should be used to determine comparables, if only one comparable is left, the entire exercise should be carried out afresh and even if there was only one comparable, the +/- 5% adjustment should be made.
• The issue is whether in determining ALP, only the companies which are functionally comparable are to be considered and whether the current year’s financial data is relevant for the determination of ALP and if only one comparable is left, the ALP cannot be determined and a fresh search of comparables should be conducted and even if there was only one comparable, the +/- 5% adjustment should be made.
• The major component of the receipt of international transaction of the assessee is commission income. It cannot be said that commission expenses which have been suo moto disallowed by the assessee were not claimed as operating expenses while computing the arm’s length price. If they are subsequently disallowed suo moto by the assessee in the revise return, they are required to be excluded from the operating cost and the calculation of the assessee should have been accepted that its profit margin should have been taken according to the income computed in the revise return for which the assessee has also paid the due taxes.
• The rejection of comparables on the ground of non-availability of the current year’s financial data is justified because under r 10B(4), only the current year’s financial data is relevant for the determination of ALP except where it is shown that the data of the earlier two years reveals facts which could have an influence on the determination of the transfer price.
• The assessee’s objection against the rejection of the other comparable, namely Alfred Haworth India Ltd, is rejected. To select a comparable, according to well recognised principle, it should also be functionally comparable. A company which is majorly dealing in other segments cannot be accepted as functionally comparable.
• The assessee’s contention that if there is only one comparable, the ALP cannot be determined and a fresh search of comparables should be conducted is also rejected. There is no principle of law that if only one comparable remains, the entire exercise would fail.
• The assessee’s contention that expenses incurred prior to the commencement of manufacturing activity hence should be excluded while computing the operating margins from the international transaction under r 10B(1)(e)(i) is rejected as operational expenses are the expenses which are incurred to earn that income. If the expenses have nexus with the revenue, then they are to be considered as operational expenses and they cannot be excluded simply for the reason that the date of the occurrence of the revenue is later and expenses have been incurred prior to that.
• The assessee’s argument that the margins have to be recomputed after claiming an adjustment of capacity utilisation is rejected. Under the TNMM, the expression “net profit margin realized” means the net profit margin actually realised and the actual cost incurred and sale affected, and thus there is no room for any assumption for taking the profit margin which has been realised. It is not permissible to deviate from the book results on the ground of capacity utilisation. Under r 10B(3)(ii), there cannot be any deviation in the net profit shown in the books of account and the adjustment, if any, can be made to the same to eliminate the material affects to such differences to the extent of these adjustments are reasonably accurate. Therefore, the position that emerges is that an adjustment can be granted to the assessee in the computation of a mean margin only to the extent of these being reasonably accurate. Further, it is the legal obligation of the assessee to keep and maintain information and documents in respect of any assumption made by it which has critically affected the determination of the arm’s length price. No credible information has been submitted by the assessee to seek an adjustment on account of the capacity utilisation of comparables, therefore the said adjustment was not permitted to the taxpayer.
• As regards the assessee’s objection that the TPO/DRP has erred in computing the quantum of adjustment to be made to the profit of the manufacturing segment of the assessee by applying the profit level indicator of operating profit/sales to the value of the international transaction pertaining to the import of raw material instead of the sales figure of the manufacturing segment which has resulted in an increase of adjustment, it is held that the DRP has not passed any speaking order on such submission of the assessee. If such a submission of the assessee were to be rejected, then reasons must should have been given for the same. There being no discussion on this issue in the order passed by the DRP, the issue is restored to the file of the DRP with a direction to consider the submissions of the assessee and to decide this issue by way of a speaking order after providing the assessee a reasonable opportunity of hearing.
• The Proviso to s 92C which gives the assessee the option to adjust the ALP by +/- 5% is applicable in a case where more than one price is determined by the most appropriate method. In a case where only one price is determined by the most appropriate method, then the benefit of 5% is not available to the assessee. As regard the marketing support system, the benefit of the proviso is not available to the assessee as only one price is determined by the most appropriate method. In respect of the manufacturing segment, more than one price is determined by most appropriate method by taking into account five comparables which have been accepted by the TPO. Therefore, for the said segment, the adjustment of 5% is available at the option of the assessee irrespective of the fact that the arm’s length price determined by the TPO exceeds 5% or not.
• The assessee has not shown how expenditures, which are claimed as provision, had accrued in the year under consideration. No details whatsoever have been filed in the paper book as no reference in the written submission regarding evidence has been made. There being no evidence on record to prove that these provisions were not in the nature of a contingent liability, there is no infirmity in the disallowance being upheld. Whenever such a claim is made, the onus is on the assessee to prove that these expenses have actually been accrued during the year under consideration.
• As regards the depreciation on printers and UPS, it is held that UPS and printers fall within the computer peripheral, hence they are eligible for a depreciation at 16%. The AO is directed to compute the depreciation accordingly.