ARM S LENGTH PRICE DETERMINATION WITH REFERENCE TO FAR ANALYSIS

Transcription

1 ARM S LENGTH PRICE DETERMINATION WITH REFERENCE TO FAR ANALYSIS INTRODUCTION: Neeraj K. Jain, FCA Vaish Associates By definition, the comparability between the controlled and uncontrolled transaction (or tax payer) is the key factor for determining the arm s length price of an international transaction. Application of arm s length principals require evaluation of economic conditions surrounding both the controlled and uncontrolled transactions. While the uncontrolled transactions need not be absolutely identical to the controlled transactions, the two must reach a desired threshold of similarity to provide a reliable benchmark and it must be possible to make adjustments for the material differences in prices or profits with sufficient accuracy. The Supreme Court in the case of Morgan Stanley and Company Inc. : 292 ITR 416 emphasized on FAR analysis (analysis of the functions performed, and associated resources employed, by the taxpayer in the controlled and uncontrolled transactions) for benchmarking exercise for determination of arm s length price of an international transaction. The Benches of the Tribunal have also laid emphasis on a systematic functional analysis for determination of arm s length price of international transaction. COMPARABILITY ANALYSIS: Comparability analysis of the controlled transaction for the enterprises participating in the controlled transactions provides a basis for characterization of the controlled transaction to be benchmarked or the characterization of the tested party. Such characterization provides the parameters for search of the potential comparables or selection and application of the most appropriate method. Thus, the first stage of comparability analysis in a Transfer Pricing benchmarking exercise is to gather all the relevant facts and circumstances surrounding the controlled transactions under review.

2 2 One of the primary factors for selection and application of the most appropriate method for determining the arm s length price is the degree of comparability between the controlled transactions and uncontrolled comparables. The functional analysis for that purpose involves evaluation of comparability factors of uncontrolled comparables for establishing comparability with the controlled transactions (or the tested party). The Delhi Bench of the Tribunal in the case of Mentor Graphics (Noida) (P) Ltd. vs. DCIT : 109 ITD 101 laid particular emphasis on this aspect of the functional analysis. Pune Bench of the Tribunal in the recent decision in the case of E-Gain Communication (P) Ltd. vs. ITO : 118 TTJ 354, after analyzing the position in this regard under the Indian Transfer Pricing Regulations, US Regulations and also OECD Guidelines, held as under: 3 7. It is clear that even when TNMM method is applied to determine arm's length price as per OECD guidelines, functional profile, assets, assumed risks of controlled and uncontrolled transaction are to he seen while screening. Besides, it is not possible to ignore specific Indian regulations on the subject. We have already noted the relevant rule (2) and (3) 10B of I.T. Rules, which specifically require to consider for comparison "the functions performed assets employed... and risks assumed by respective parties" In Rule 10(B)(1)(c) of I.T. Rules providing for determination through TNMM, it is clearly provided in clause (iii) "the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the difference if any". These regulations have force of law and notwithstanding OECD guidelines, the T.P.O. can not refuse to consider specific characteristics of transaction, functions performed and assets employed as has been done in this case. xxx xxx xxx xxx xxx 36. It is thus evident from above that both OECD guidelines and US regulations insist on necessary adjustments for difference on issues affecting profitability. The transactional net margin method may afford a practical solution to otherwise insoluble transfer pricing problems if it is used sensibly and with appropriate adjustments to account for differences of the type referred to above. Similarities and dissimilarities of the transactions under comparison are to be scrutinized to see differences of situations, circumstances and environment. Any difference which materially affects the market value is to be given a serious consideration. The degree of comparability between the tested party and the uncontrolled taxpayer with parameters like nature or line of business, product or service market, the assets composition employed, the size and scope of operation, the stage of business or product cycle are required to be seen. In case of uncontrolled entity, operative income attributable to assets other than assets under consideration is to be adjusted before taking

3 3 transaction for working mean margin of profit. Income and expenses of the segment of total business may have to be considered. Depending on facts and circumstances of the case, "It may also be appropriate to adjust the operative profit of tested party and comparable parties". Thus, the determination of arm s length price of a controlled transaction involves functional analysis at two stages, viz., for characterization of the international transaction (or the tested party) and for establishing comparability between the controlled and uncontrolled transactions. COMPARABILITY FACTORS: The US Regulations set forth five nonexclusive comparability factors to be considered in determining comparability and the extent to which adjustments are necessary, viz., (1) Functions, (2) Contractual terms; (3) Risks; (4)Economic conditions and (5) Property or services. The OECD Guidelines, too, lists similar comparability factors. However, the OECD Guidelines includes risks as part of functional analysis. (1) Functions: Functional analysis is finding and organizing facts about a business in terms of its functions performed, risks and tangible and intangibles, assets utilized in order to analyze how these are allocated between the companies involved in the transactions under review. Functional analysis must identify and compare the economically significant activities (key value drivers) involved in the controlled and uncontrolled transactions. The consideration of the resources employed should include a consideration of the type of assets used, such as plant and equipment, or the use of intangibles. The functions that may need to be considered are - (i) research and development, (ii) product design and engineer, (iii) manufacturing, production and process engineering, (iv) product fabrication, extraction and assembly, (v) purchasing and materials management, (vi) marketing and distribution, (vii) transportation and warehousing and (viii) managerial, legal, accounting and finance, credit and collection, training and personnel management services. (2) Contractual Terms: A comparison of significant contractual terms is required in comparing controlled and uncontrolled transaction. The Regulations

4 4 specify seven nonexclusive contractual terms that could affect the comparability of the controlled and uncontrolled transactions i) the form of consideration charged or paid; ii) sales or purchase volume; iii) the scope and terms of warranties; iv) rights to updates, revisions or modifications; v) the duration of relevant license, contract or other agreements, and termination or renegotiation rights; vi) collateral transactions or ongoing business relationships between the buyer and seller, including arrangements for the provision of ancillary services; and vii) the extension of credit and payment terms. (3) Risks: In determining the degree of comparability between controlled and uncontrolled transactions, it is necessary to compare the significant risks that could affect prices or profits. The Regulations specifically identify six categories of risk i) market risks, including fluctuations in cost, demand, pricing and inventory levels; ii) risks associated with R&D; iii) financial risks (including currency and interest rate risk); iv) credit and collection risks; v) product liability risks and vi) general business risks related to the ownership of property, plant and equipment. (4) Economic Conditions: The US Regulations identify eight significant economic conditions that can affect prices or profits: i) the similarity of geographic markets; ii) the relative size of each market and its level of economic development; iii) the level of the market; iv) the applicable market shares for the relevant products, properties or services; v) the location-specific costs of production and distribution; vi) the extent of competition in each market for the relevant products or services; vii) the economic condition of the particular industry and viii) the alternatives realistically available to the buyer and seller. (5) Property or Services: Finally, determining the comparability of controlled and uncontrolled transactions requires a comparison of the property or

5 5 services transferred in such transactions. The comparison should take into account any embedded intangibles. Intangibles are ordinarily divided into two categories: manufacturing and marketing. Manufacturing intangibles are characterized as one of two types patents or non-patented technical know-how and arise out of either R&D activity or the production engineering activities of the manufacturing plant. Marketing intangibles include trademarks, corporate reputation, the distribution network and the ability to provide services to customers before and/or after the sale. This category of intangibles is very broad indeed, and regard must be had to the question of ownership of such assets as well as to their maintenance and development. The pricing method chosen affects the relative importance of product comparability in determining the relative reliability of the results. For example, a high degree of product comparability is required for the CUP method to be reliable. CHARATERIZATION OF BUSINESS: Characterization of the international transactions and/or business of the participating enterprise is an important component to a transfer pricing analysis and is used as the foundation in developing the economic analysis. Characterization of businesses means making comparisons of the functions, assets and risks of the related entities under review for comparing those with uncontrolled entities that exist in the same or similar industry. Such characterization involves using information from the functional analysis and information about the industry. (a) Contract or full-fledged manufacturer (or service provider): The two general characterization for a manufacturing (or service) businesses are contract manufacture (or service provider) or full fledged manufacturer (or service provider). Commensurate with the functions performed and risks, the return received by a contract manufacturer (or service provider) would generally be lower than that of a full fledged manufacturer (or service provider).

6 6 Contract manufacturers Fully-fledged manufacturers - Does not own technology Owns technology - Little risk Full of risk - Purchasing - Little discretion in production Production scheduling scheduling - Does not totally control equipment - Scheduling Select own equipment scheduling - Quality control usually dictated Direct control over quality by customer - Usually manufacturing high volume, high volume mature products Manufacturing products at all high volume mature products stages of product life cycle. (b) Characterization of distribution/selling companies: There are four general characterizations of distribution/selling companies. These are in order of increasing functions, manufacturer s representative (or commission agent), limited distributor, distributor and marketer/distributor. This characterization is important because the prices paid/profits earned vary, sometimes considerably, between these various types of selling entities, with the manufacturer s representative earning the least profit of all. Manufacturer s representative (or commission agent) Limited distributor Distributor Marketer Distributor Does not take title Takes title Takes title Takes title No credit risk minimal/parent controls policy Credit risk Credit risk Credit risk No inventory risk Inventory risk minimal inventory risk Inventory risk Inventory risk No marketing responsibilities limited Marketing responsibilities Marketing responsibilities limited Total marketing responsibilities No FX risk No FX risk May or may not have FX risk May or may not have FX risk

7 7 ADJUSTMENTS TO COMPARABLES: Functional analysis as a tool of information on international transaction (or tested party) should facilitate adjustments that may be required so that the financial results of the comparables are stated on the same basis as those of the tested party. To achieve a functional comparability, adjustments may be made to the financial statements of the comparables in one or more of the following ways:: (i) Accounting Consistency: Accounting differences between the tested party and comparables may lead to measurement errors, if adjustments are not made. Adjustments may be necessary to ensure accounting consistency with the tested party s measurement of operating results. (ii) Restatements: Restatement adjustments can be made to ensure consistency with the tested party s measurement of trading assets and liabilities and operating profit. Divestment or acquisition, if they impact the comparability, may require restatement of the financials to exclude divested or acquired businesses. (iii) Segmentation and elimination of significant non-comparabilities: If financial statements of the potential comparables, with significant noncomparable operations, disclose sufficient segmented financial information (e.g., segmented sales, operating profit, and identifiable assets for comparable and non-comparable segments), a segmentation procedure can be used to eliminate these returns from the return on comparable functions. (iv) Adjustment for functional differences: Adjustments to address differences between and among the comparables and the tested party in the functions performed can be classified into three distinct categories: (a) adjustments for differences in the amount of working capital required; (b) adjustments for differences in the mix of functions performed; and (c) adjustments for the presence of significant intangibles. (a) Working capital adjustment - It is very common for the tested party and each of the comparables to differ substantially in the amount of working capital.

8 8 Such differences are generally caused by differences in the financing terms of purchase and sale that the company receives from its suppliers and extends to its customers, and by differences in the levels of inventories held by the company. Such differences generate substantial differences in the capital structure and operating profits of the companies. In order to reduce the effect of differences in terms of purchase and sale and levels of inventories on the profitability measures, adjustments are made to normalize the receivables, payables, and inventory levels of the comparables and the tested party. The receivable, payables, and inventory balances are adjusted such that the days of each held are equivalent to a normalized number of days. Operating profit is adjusted, in parallel, to reflect the return required in order to hold the increased level of payables, receivables, or inventories. [Working capital adjustment upheld by the Delhi Bench of the Tribunal in Sony India (P) Ltd. (ITA No. 1189/Del/2005)]. (b) Difference in functional mix - Often, significant differences in the mix of functions performed by the comparables vis-à-vis the tested party exist. For example, a controlled distribution company may differ from a set of independent distribution companies in that it performs import and regulatory functions not performed by the independent distributors, performs only first-tier distribution functions, and performs limited manufacturing and assembly functions. To adjust for such differences, the financial results of the comparables and the tested party may be adjusted to eliminate the margins associated with the functions not considered relevant or include indicated returns for relevant functions not performed by the comparables. Such adjustments can be performed by reference to the returns earned by companies that perform solely those functions or the return on expenses earned by the tested party on the functions performed. As an illustration, we may consider adjustments performed to iron out the differences in the mix of functions performed by a controlled medical equipment distributor and a set of independent medical equipment distribution comparables. In this example, the comparables financial results were adjusted to eliminate the portion of their margins associated with manufacturing and assembly operations and with downstream second-tier distribution functions based upon the profitability earned by comparable manufacturing companies and pure second-

9 9 tier distribution companies. The margins of those comparables that did not perform import and regulatory functions may be increased to reflect the returns associated with these functions based on the tested party s expense ratio to sales for such functions and the comparables profit to SG&A (sales, general and administrative expenses) ratio. (c) Presence of significant intangibles - Adjustments must be made if comparables do not possess the same level or type of non-routine intangibles as the tested party. If, for instance, the comparables profits are partially attributable to significant, non-routine intangibles, such as product design or engineering, that are not present in the tested party, a statistical analysis to estimate the effects of such intangibles on operating profits may be performed to isolate and adjust for the effect of the intangibles on profitability. (v) Adjustment for differences in transactional structure between the comparables and the tested party: Determination of arm s length price of international transaction may require adjustment on account of differences in transaction structure between controlled transaction, e.g., sales by the controlled enterprise, and similar transaction involving independent company. These problems arise in controlled situations when the parties allocate the risks and functions of the enterprise among themselves in a way that they would not if they were independent. The differences in the bargaining power and degree of common interest of the related parties and the independent companies may lead to very different transaction terms, such as extremely long-lived contracts, or instances where unique intangibles that would not ordinarily be transferred between unrelated companies are undertaken between the controlled parties. Thus, when material differences in the structure of the transaction exist between a set of potential comparables and the tested party due to the very fact that the transactions to be priced are not arm s length, the search for comparables that have the same transactional structure is fruitless. In these circumstances, the tax payer will need to adjust the financial results of the comparables (or the tested party) to reflect these differences. For example, the margins observed in

10 10 independent distribution relationships may not be comparable to those in longrun, related party situations unless an adjustment is made to account for the shorter duration of the supply relationship. In this case, the total amount of marketing investment required to launch a product and the yearly profit required to recoup this investment plus a fair return over different investment horizons is determined. The difference between the yearly profit required to recover the investment over the comparables investment horizon and over the tested party s investment horizon is the amount by which yearly profits are adjusted. CONCLUSION: For undertaking an undisputable benchmarking exercise for determination of arm s length price of international transaction, it is imperative both for the tax payer as well as Transfer Pricing Officers to go through the arduous process of investigation and understanding of the facts surrounding the inter-company transactions by undertaking a systematic functional analysis. This may involve interviews, examination of documents and understanding of business to obtain in-depth information regarding functions, risks and intangibles of each legal entity. This may identify further areas for review, including relevant contracts and financial data. Industry associations and publications may also be consulted to understand standard operating practices within the industry as well as the key value drivers involved in the transaction. ************