Transfer Pricing: Analysis of provision for computation of arm's length price.

[C.A. DEV KUMAR KOTHARI]

Transfer pricing:

When we speak about transfer pricing or pricing on arm’s length basis we need to consider only comparable transactions in all aspects. Incomparable transactions cannot be basis of comparison or determination of fair price. In practice we find that several methods can be applied to determine fair price or price which can be fetched in open market.

Comparability:

Major factors about product to be supplied are the place of contracting, place of execution,  time of execution and spread of time involved, volume  in transaction vis a vis  transactions with which comparison is to be made, risks as to acceptance or rejection of product, risks of return of goods and associated costs and losses, major  terms and conditions about  inspections, approval, payment, penalties for defaults and delays, contingencies in execution and payments etc. are major factor which need to be considered in any contract, when we compare it with other contract or transaction.

Other factors which need to be considered for comparable transactions are related with competition, volatility in price of product and raw material and major other inputs. For example, heavy raw materials may face volatile market in particular region whereas in other reason its price may not be so volatile. Similar situation can be about price volatility of finished goods. A supplier operating from one place may not be comparable with supplier operating form some other place.   

In case of items having free market, worldwide market or limited markets as the case may be, and extent of applicable competition, market price at the time of entering into contract, past price trend, expected price trend in near future and at the time of delivery schedule, and all relevant factors need to be considered as a prudent businessman would do while submitting bid or offer as the case may be.

For example two contracts entered into on the same day or within short gap of time may not be comparable for any of the illustrative reasons:

1. The volume is not comparable one transaction is of 10 MT other is of 500 MT.
2. The delivery period is different- in one transaction there is immediate delivery, in another delivery is spread over six months.
3.  One customer is a casual customer, another is regular customer.
4. One customer pays in advance, another purchases on three or six months credit. Longer the period of credit, higher will be contingencies of recovery of dues.
5. One customer is a small organisation, the other is a big organisation. 
6. The locations of two customers are such that they cannot be called comparable and have major impact on decision as to supplying as well as pricing.
7. One customer is a sick industry- his track record of payment is not very encouraging whereas another is a profit making industry and have good track of payment. 

On consideration of all facts, we need to examine comparability of transactions. In a case, provisions may not attract at all or there may be many reasons for which the provision may not be applicable at all. Therefore, this is a serious aspect and one need to examine the same thoroughly.

Most appropriate method:

As per the provision of the I.T. Act and I.T. Rules, we need to consider the ‘most appropriate method’ for determination of ALP, if the TP – ALP provisions are attracted.

Relevant provisions with highlights marked in red colour, are reproduced in this write-up.

Income-tax Act, 1961

Computation of arm's length price.

     92C. {(1) The arm's length price in relation to an ⁷[international transaction or specified domestic transaction] shall be determined by any of the following methods, {being the most appropriate method}***, having regard to the nature of transaction or class of transaction or class of associated persons or functions performed by such persons or such other relevant factors as the Board may prescribe, namely :—

           (a) comparable uncontrolled price method;

           (b) resale price method;

           (c) cost plus method;

           (d) profit split method;

           (e) transactional net margin method;}*

           (f) such other method as may be prescribed by the Board.**

      (2) The most appropriate method referred to in sub-section (1) shall be applied, for determination of arm's length price, in the manner as may be prescribed:

     ¹[Provided that where more than one price is determined by the most appropriate method, the arm's length price shall be taken to be the arithmetical mean of such prices:

     Provided further that if the variation between the arm's length price so determined and price at which the ⁷[international transaction or specified domestic transaction] has actually been undertaken ⁵[does not exceed such percentage not exceeding three per cent of the latter, as may be notified] by the Central Government in the Official Gazette in this behalf] the price at which the ⁷[international transaction or specified domestic transaction]  has actually been undertaken shall be deemed to be the arm's length price. ]

     ⁶[Explanation.—For the removal of doubts, it is hereby clarified that the provisions of the second proviso shall also be applicable to all assessment or reassessment proceedings pending before an Assessing Officer as on the 1st day of October, 2009.]

     ⁶[(2A) Where the first proviso to sub-section (2) as it stood before its amendment by the Finance (No. 2) Act, 2009 (33 of 2009), is applicable in respect of an ⁷[international transaction or specified domestic transaction] for an assessment year and the variation between the arithmetical mean referred to in the said proviso and the price at which such transaction has actually been undertaken exceeds five per cent of the arithmetical mean, then, the assessee shall not be entitled to exercise the option as referred to in the said proviso.]

     ⁶[(2B) Nothing contained in sub-section (2A) shall empower the Assessing Officer either to assess or reassess under section 147 or pass an order enhancing the assessment or reducing a refund already made or otherwise increasing the liability of the assessee under section 154 for any assessment year the proceedings of which have been completed before the 1st day of October, 2009.]

      (3) Where during the course of any proceeding for the assessment of income, the Assessing Officer is, on the basis of material or information or document in his possession, of the opinion that—

           (a) the price charged or paid in an ⁷[international transaction or specified domestic transaction] has not been determined in accordance with sub-sections (1) and (2); or

           (b) any information and document relating to an ⁷[international transaction or specified domestic transaction] have not been kept and maintained by the assessee in accordance with the provisions contained in sub-section (1) of section 92D and the rules made in this behalf; or

           (c) the information or data used in computation of the arm's length price is not reliable or correct; or

           (d) the assessee has failed to furnish, within the specified time, any information or document which he was required to furnish by a notice issued under sub-section (3) of section 92D,

the Assessing Officer may proceed to determine the arm's length price in relation to the said ⁷[international transaction or specified domestic transaction] in accordance with sub-sections (1) and (2), on the basis of such material or information or document available with him:

     Provided that an opportunity shall be given by the Assessing Officer by serving a notice calling upon the assessee to show cause, on a date and time to be specified in the notice, why the arm's length price should not be so determined on the basis of material or information or document in the possession of the Assessing Officer.

      (4) Where an arm's length price is determined by the Assessing Officer under sub-section (3), the Assessing Officer may compute the total income of the assessee having regard to the arm's length price so determined:

     Provided that no deduction under section 10A ²[or section 10AA] or section 10B or under Chapter VI-A shall be allowed in respect of the amount of income by which the total income of the assessee is enhanced after computation of income under this sub-section:

     Provided further that where the total income of an associated enterprise is computed under this sub-section on determination of the arm's length price paid to another associated enterprise from which tax has been deducted ³[or was deductible] under the provisions of Chapter XVIIB, the income of the other associated enterprise shall not be recomputed by reason of such determination of arm's length price in the case of the first mentioned enterprise. 

{Related  Rules are Rule 10AB,10B and 10C}

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Notes :-

1.  Substituted vide Finance (No.2) Act, 2009, w.e.f. 1-10-2009, before it was read as, "Provided that where more than one price is determined by the most appropriate method, the arm's length price shall be taken to be the arithmetical mean of such prices, or, at the option of the assessee, a price which may vary from the arithmetical mean by an amount not exceeding five per cent of such arithmetical mean."

2. Inserted by the Finance Act, 2006, w.e.f.1-4-2007.

4. Substituted vide Finance Act, 2011, w.e.f. 1.4.2012, before it was read as, “five per cent of the latter”

5. Substituted vide Finance Act, 2012, w.e.f. 01-04-2012, before it was read as:- “does not exceed ⁴[percentage of the latter, as may be notified”

6. Inserted vide Finance Act, 2012, w.e.f. 01-04-2012

7. Substituted vide Finance Act, 2012, w.e.f. 01-04-2012, before it was read as:- "international transaction"

* see Rule 10B

** See Rule 10AB

*** See Rule 10C

Income-tax Rules, 1962

¹[Other method of determination of arm's length price

10AB. For the purposes of clause (f) of sub-section (1) of section 92C, the other method for determination of the arms' length price in relation to an international transaction shall be 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.] 

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Notes:-

1. Inserted vide Notification No. 18/2012, Dated 23-5-2012

Determination of arms length price under section 92C.

10B. (1) For the purposes of sub-section (2) of section 92C, the arms length price in relation to an international transaction shall be determined by any of the following methods, being the most appropriate method, in the following manner, namely:-

(a)    comparable uncontrolled price method, by which,-

     (i)   the price charged or paid for property transferred or services provided in a comparable uncontrolled transaction, or a number of such transactions, is identified;

     (ii)  such price is adjusted to account for differences, if any, between the international transaction and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which could materially affect the price in the open market;

     (iii) the adjusted price arrived at under sub-clause (ii) is taken to be an arms length price in respect of the property transferred or services provided in the international transaction;

(b) resale price method, by which,-

     (i)   the price at which property purchased or services obtained by the enterprise from an associated enterprise is resold or are provided to an unrelated enterprise, is identified;

     (ii)  such resale price is reduced by the amount of a normal gross profit margin accruing to the enterprise or to an unrelated enterprise from the purchase and resale of the same or similar property or from obtaining and providing the same or similar services, in a comparable uncontrolled transaction, or a number of such transactions;

     (iii) the price so arrived at is further reduced by the expenses incurred by the enterprise in connection with the purchase of property or obtaining of services;

     (iv) the price so arrived at is adjusted to take into account the functional and other differences, including differences in accounting practices, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of gross profit margin in the open market;

     (v)  the adjusted price arrived at under sub-clause (iv) is taken to be an arms length price in respect of the purchase of the property or obtaining of the services by the enterprise from the associated enterprise;

(c) cost plus method, by which,-

     (i)   the direct and indirect costs of production incurred by the enterprise in respect of property transferred or services provided to an associated enterprise, are determined;

     (ii)  the amount of a normal gross profit mark-up to such costs (computed according to the same accounting norms) arising from the transfer or provision of the same or similar property or services by the enterprise, or by an unrelated enterprise, in a comparable uncontrolled transaction, or a number of such transactions, is determined;

     (iii) the normal gross profit mark-up referred to in sub-clause (ii) is adjusted to take into account the functional and other differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect such profit mark-up in the open market;

     (iv) the costs referred to in sub-clause (i) are increased by the adjusted profit mark-up arrived at under sub-clause (iii);

     (v)  the sum so arrived at is taken to be an arms length price in relation to the supply of the property or provision of services by the enterprise;

(d) profit split method, which may be applicable mainly in international transactions involving transfer of unique intangibles or in multiple international transactions which are so interrelated that they cannot be evaluated separately for the purpose of determining the arms length price of any one transaction, by which-

     (i)   the combined net profit of the associated enterprises arising from the international transaction in which they are engaged, is determined;

     (ii)  the relative contribution made by each of the associated enterprises to the earning of such combined net profit, is then evaluated on the basis of the functions performed, assets employed or to be employed and risks assumed by each enterprise and on the basis of reliable external market data which indicates how such contribution would be evaluated by unrelated enterprises performing comparable functions in similar circumstances;

     (iii) the combined net profit is then split amongst the enterprises in proportion to their relative contributions, as evaluated under sub-clause (ii);

     (iv) the profit thus apportioned to the assessee is taken into account to arrive at an arms length price in relation to the international transaction :     

Provided that the combined net profit referred to in sub-clause (i) may, in the first instance, be partially allocated to each enterprise so as to provide it with a basic return appropriate for the type of international transaction in which it is engaged, with reference to market returns achieved for similar types of transactions by independent enterprises, and thereafter, the residual net profit remaining after such allocation may be split amongst the enterprises in proportion to their relative contribution in the manner specified under sub-clauses (ii) and (iii), and in such a case the aggregate of the net profit allocated to the enterprise in the first instance together with the residual net profit apportioned to that enterprise on the basis of its relative contribution shall be taken to be the net profit arising to that enterprise from the international transaction;

 (e)  transactional net margin method, by which,-

       (i)  the net profit margin realised by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base;

      (ii)  the net profit margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base;

      (iii)  the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market;

      (iv)  the net profit margin realised by the enterprise and referred to in sub-clause (i) is established to be the same as the net profit margin referred to in sub-clause (iii);

      (v)  the net profit margin thus established is then taken into account to arrive at an arms length price in relation to the international transaction.

   ¹[(f) Any other method as provided in rule 10AB.]

(2) For the purposes of sub-rule (1), the comparability of an international transaction with an uncontrolled transaction shall be judged with reference to the following, namely:-         

       (a)  the specific characteristics of the property transferred or services provided in either transaction;         

      (b)  the functions performed, taking into account assets employed or to be employed and the risks assumed, by the respective parties to the transactions;        

      (c)  the contractual terms (whether or not such terms are formal or in writing) of the transactions which lay down explicitly or implicitly how the responsibilities, risks and benefits are to be divided between the respective parties to the transactions;       

      (d)   conditions prevailing in the markets in which the respective parties to the transactions operate, including the geographical location and size of the markets, the laws and Government orders in force, costs of labour and capital in the markets, overall economic development and level of competition and whether the markets are wholesale or retail.

(3) An uncontrolled transaction shall be comparable to an international transaction if-          

      (i)  none of the differences, if any, between the transactions being compared, or between the enterprises entering into such transactions are likely to materially affect the price or cost charged or paid in, or the profit arising from, such transactions in the open market; or         

      (ii)  reasonably accurate adjustments can be made to eliminate the material effects of such differences.

(4) The data to be used in analysing the comparability of an uncontrolled transaction with an international transaction shall be the data relating to the financial year in which the international transaction has been entered into:

Provided that data relating to a period not being more than two years prior to such financial year may also be considered if such data reveals facts which could have an influence on the determination of transfer prices in relation to the transactions being compared. 

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Notes:-

1. Inserted vide Notification No. 18/2012, Dated 23-5-2012

Most appropriate method.

10C.(1) For the purposes of sub-section (1) of section 92C, the most appropriate method shall be the method which is best suited to the facts and circumstances of each particular international transaction, and which provides the most reliable measure of an arms length price in relation to the international transaction.

(2) In selecting the most appropriate method as specified in sub-rule (1), the following factors shall be taken into account, namely:

(a)	the nature and class of the international transaction;
(b)	the class or classes of associated enterprises entering into the transaction and the functions performed by them taking into account assets employed or to be employed and risks assumed by such enterprises;
(c)	the availability, coverage and reliability of data necessary for application of the method;
(d)	the degree of comparability existing between the international transaction and the uncontrolled transaction and between the enterprises entering into such transactions;
(e)	the extent to which reliable and accurate adjustments can be made to account for differences, if any, between the international transaction and the comparable uncontrolled transaction or between the enterprises entering into such transactions;
(f)	the nature, extent and reliability of assumptions required to be made in application of a method.