Transfer pricing Study Steps

The basic theme while carrying out TP study is to gain understanding on the following aspects

a) Understanding of economically significant characteristics of controlled transaction b) Understanding of respective role of parties in controlled transaction c) Comparison of conditions of controlled transaction and conditions in uncontrolled

transaction taking place in comparable circumstances

Economically Significant characteristic of controlled transaction and respective role of parties, which could materially affect prices or profits in transaction, is determined by evaluating 5 comparability factors as under:-

1. Characteristic of property or service transferred 2. Functions performed by parties taking into assets employed and risk assumed. (FAR or

Functional analysis) 3. Contractual terms 4. Economic circumstances 5. Business Strategies

The steps involved in transfer pricing study are as under:-

1. Understanding basic information on enterprises & Controlled transaction 2. Evaluation of 5 comparability factors 3. Selecting testing party & Preliminary decision on transfer Pricing Method applicable based

on respective features, strengths and weakness of each of the methods. 4. Development of search criterion for identification of comparables 5. Identifying potential comparable transaction 6. Comparability adjustment where appropriate 7. Selection of most appropriate transfer pricing method 8. Determination of arm’s length price of profits (or range of prices or profits) 9. Documentation of comparability analysis

If upon performing step 5 & 6, no suitable comparables can be found, then steps from 3 onwards has to repeat again, adopting different probable most appropriate method.

1. Gain understanding on basic information on enterprise and controlled transaction on

following aspects:- a) Collection of information about taxpayer to understand its business operation and

activities i.e, industry to which taxpayers belong, the nature of its activities ( i.e manufacturer, wholesaler, distributor etc.) , its market segment, market share etc.

b) Identification of associated enterprises involved in controlled transaction c) Nature of controlled transaction, Nature of products/services transferred, value thereof,

terms and conditions, type of intangible used. d) Gain understanding of industry, competition, economy, regulatory factors and other

elements that may significantly affect the taxpayer and its environment

2. Comparability factors Enterprise and controlled transaction should be evaluated on following 5 factors:-

a) Characteristic of the property or services transferred. b) FAR Analysis c) Contractual Terms d) Economic Circumstances e) Business strategies.

The above-said analysis should culminate in arriving at the following:-

a) Tested party- The tested party should normally be the least complex party to the controlled transaction and should be party in respect of which the most reliable and data for comparability is easily and readily available.

b) Preliminary decision on transfer Pricing Method applicable based on respective features, strengths and weakness of each of the methods.

c) Development of search criterion for identification of comparable

a. Characteristics of Property or service transferred. Product comparability holds prime importance, if Comparable uncontrolled price method is to be followed. In general following features needs to be captured to evaluate the Characteristics of Property or service:- a) In case of tangible property, the physical features, quality & reliability, brand. b) In case of services, nature and extent of services c) In case of intangible property, the form of the transaction (License or sale), Type &

form of property (Marketing Intangibles- Trademark, Trade name or Production Intangibles – Patent, Know-how etc.), duration and degree of protection, anticipated benefits from use of property.

In case of Resale price Method, Cost Plus Method, the strict product comparability is not required, but following features merit attention:- a) Category of Product or Service- For example Tangible goods can be categorized as

“home entertainment”, “household appliances” or “machine tools”, etc. b) Product Life Cycle - For Example all sorts of TV, whether Normal TV, LCD, LED falls

under Home entertainment, but normal TV is only declining phase, LCD is on stagnating phase and LED is on rising phase. Their margin cannot be same.

Though TP methods will be determined post FAR analysis, the reference to methods above given for understanding purpose only. In Recent judgment by Mumbai Tribunal in Serdia Pharmaceutical, it was held that Brand is not distinguishing factor to establish product comparability. The gist of the case is as under;- a) Assessee is engaged in manufacturing and distribution of Drugs in Finished Dosage

Forms (FDF). Assessee was commanding huge market share and also claiming to have purity level much higher than its peers because of its brand.

b) It was importing API from its AE, whose patents has expired, international transaction. c) Assessee was paying higher price for API imported from AE, which was available at

cheaper price than procured from AE. d) Assessee adopted TNMM and carry out is TP study.

e) TPO rejected TNMM and adopted CPU as most appropriate method for benchmarking API imported from AE.

f) Court upheld that TPO stand.

b) FAR – Analysis FAR Analysis refers to Analysis of Functions Performed, Assets Used, Risk Undertaken by respective parties in controlled Transactions.

Functions The range of functions performed can be broadly categorized into following:- i) Manufacturing of goods ii) Distribution of goods iii) Service Provider

i) Manufacturing Function Assessee engaged in manufacturing business, can be broadly divided into 2 categories based on functions performed:- a) Contract Manufacturer b) Full-fledged Manufacturer

Contract Manufacturer 1. They do not develop their own product line but offer expertise in performing certain

manufacturing operations 2. They may or may not perform such functions as material purchasing and production

scheduling or own inventory. 3. They do not face direct marker risk as they guaranteed revenue stream 4. The contract manufacturer intangibles are limited and typically consist of know-how

pertaining to manufacturing process. 5. Little risk 6. Quality Control usually dictated. 7. Usually manufacturing high volume, mature products

Full-fledged Manufacturer

1. They develop their own product lines and may have substantial R&D Budget or may obtain the technology they require through license.

2. They perform all manufacturing functions, such as vendor qualification, materials purchasing, production scheduling and quality control procedures.

3. They are typically extensively involved in marketing to the ultimate customers (or end-users) of the product.

4. They bear several types of risk, including inventory risk and market risk. 5. Direct control over quality.

Categorization of assessee business, i.e whether contractor or full-fledged manufacturer, helps in identification of comparables

Manufacturing Functions- Following functions needs to evaluated for assessee engaged in manufacturing activities so as to arrive at proper categorization of business:-

1) R&D and Technology a. What R&D is undertaken? b. Is R&D carried out on the firm’s behalf by related companies c. Are third parties engaged to carry out research and development d. Where are the products designed e. How important is the development of the patent in the industry. f. What patents are owned that create unique products competitors cannot

duplicate. g. What unpatented technical know-how has been developed that might

differentiate its products from competitors, create important cost efficiencies or provide an advantage in increasing market share.

2) Product Strategy and Design.

Product strategy and design is the process by which a firm decides which market segment to pursue, what product characteristic are needed to meet the market demand, the types of products that will be produced to satisfy the demands and selection of materials and processes that will create these products.

3) Manufacturing process a. What is manufacturing process ? How are the firm’s goods manufactured- the

most important steps involved. b. Who developed the original process c. How fast does it change. d. Have any improvements been made locally. e. Has the firm utilized a third party to manufacture its products.

4) Purchasing

The purchasing function involves identifying and qualifying vendors, arranging delivery from vendors and providing quality control. Who performs the purchasing function, plans purchasing schedules, negotiates purchasing arrangements and approves the vendor of being acceptable quality.

5) Inward Logistics

Inbound logistics includes transportation, warehousing and other functions necessary to co-ordinate the movement of materials to production site from unrelated and related party processing or distribution facilities.

6) Packaging and labeling

The packaging and labeling function refers to the manner in which a product is packaged and labeled for shipment to a buyer. Packaging and labeling requirements are often affected by a legal and regulatory environment of the party shipping and the party receiving the products

a) What packaging and labeling is done b) Where it is done c) Who makes the decision in relating to packaging and labeling

7) Production scheduling The production scheduling function is undertaken by manufacturer to determine which products are to be manufactured, when they are to be manufactured and what production volumes should be achieved for the products. a) Who schedules production? b) Who/what influence the production schedule c) Who determines the product mix? d) Who controls the inventory levels e) What is the inventory holding period.

8) Outward logistics

Same as inbound logistics.

ii) Distribution Function Assessee engaged in distribution business, can be broadly divided into 3 categories based on functions performed:- a) Manufacturer’s Representative b) Limited Distributor c) Marketer/Distributor

Manufacturer’s Representative 1. Does not take title to goods 2. It bears neither credit risk nor inventory risk 3. It does not have marketing responsibilities 4. He is typically remunerated by way of commission on the sales revenue generated

Limited Distributor 1. Takes title to goods 2. Limited credit and inventory risk but not bear foreign exchange risk on purchase from its

suppliers 3. Limited marketing responsibilities

Marketer/Distributor 1. Takes title to merchandise 2. Bear credit & inventory risk and may have foreign exchange risk 3. Total marketing responsibilities for its product lines

Marketing, Advertising and Distribution. Marketing is broad definition encompassing following activities: -advertising, market research, media planning, public relations, product pricing, distribution, customer support, sales strategy, and community involvement.

Marketing 1) Marketing strategy and Development

Marketing strategy and development functions are those activities that determine the positioning of a firm’s product in a market and establish marketing techniques that bring products to the customer’s attention. a. Which entities perform marketing function. b. Are market survey performed. c. Which entities monitor market demand.

d. What are the risks related to demand for the firm’s products. e. Who formulate the marketing budget f. Do related companies undertake marketing?

2) Marketing & Advertisement Marketing function includes overall development of brand awareness in the market place and the creation and implementation of product specific campaigns

a) What form of marketing does firm utilize? b) What form of advertising is used? c) Who pays for it d) Are trade shows used, and if so, who organize them and who pays for them e) Are sample provided to distributor

Distribution 3) Sales and Pricing

Product pricing has strategic and tactical components. Strategic pricing involves a trade-off between products margins and sales volume. Tactical aspects involve price adjustments to meet local or temporary market conditions, establish prices for product improvements or assist distributor in meeting competitive challenges a. How price determined? b. Which is more important in determining the pricing structure: Product margin or volume? c. Is there published price list? d. On a tactical level, can prices be changed to meet specific customer demand? e. What approvals are necessary? f. Who formulates the projection and sets targets g. Who is responsible for achievement of sales targets? h. Who negotiates sales contract

4) Distribution Network Distribution network enable the firm to locate customers, determine their needs and provide services or products to meet those needs. In addition, these networks enhance firm’s development of a trademark/trade name

a) How is the products distributed b) Who has developed the distribution network c) Were customer list obtained through acquisition d) How responsive is the distribution to changes in the marketplace e) Who manages the network f) Has the network expanded or contracted in the recent years

Others 5) Order Processing

The order processing function involves taking the customer order from sales personnel, relaying the product order to inventory control personnel, ensuring the order includes all requested items and relaying the products to the shipping department and billing information to the accounting office.

a) Where are sales orders received?

b) Who issues the invoice to the customer? c) Who track the fulfillment of an order? d) To whom does the customer speak to determine the status of an order 6) Installation and after sale services

After sale services is means by which a firm differentiated its products from others. After sale services includes developing technical support and training for distributors and dealers; providing distributors with advice and training to improve operations and profitability ; and ensuring component availability

a) Does the firm undertake installation of its products b) Does the firm provides after sale services c) Who bears the cost of installation and after sale services 7) Warranty Support

The Warranty support function is generally performed by the entity from which the customer receives a level of services prescribed by the legal obligation under the warranty.

a) Are the firm’s product under warranty b) What are the terms of the warranty c) Who establishes the terms d) Who fulfills the obligation of warranty e) Are unrelated party vendors involved f) Who bears the cost

ASSET USED The analysis should involve identification of the type of capital asset used (e.g plant & equipment, intangible assets, financial assets etc) and the nature of assets used, such as the age, market value, location, property right protection available. Usage of asset under FAR analysis is more relevant in manufacturing concern, where value and age of assets do have effect on Price or profitability.

Risk Analysis

1. Market Risk – It occurs due to increased competition in the market, adverse demand conditions in the market or inability to develop markets or position products to service targeted customers a. What are market risks b. How significant are market risk c. Which entity bears the market risk d. Do competitors bear the same risk. e. How do competitors react? The extent of market risk depends on the degree of competition and economic structure in market. The existence of limited competition within a particular industry or product sector can arise from a number of factors. Barriers to entry by new firms, such as government regulation or the need for an extremely large initial investment (the development and commercialization of new drugs in the ethical pharmaceutical market is a good example). Even if there is more than one firm in the industry in question, a company can establish a competitive advantage by developing a patent or proprietary know-how that essentially bars or inhibits competition

in a particular product or market. If such barriers exist, they can have a material impact on the degree of market risk faced by a particular firm. Market risk also vary with sensitivity of the industry to general economic conditions.

2. Product liability risk- It is borne by a firm when its products fail to perform at accepted or advertised standards. Often product liability risk develop when by failing to perform to standards, a product cause its users bodily harm a) What precautions are taken to protect the firm from product liability risk b) How significant is the risk c) Is there insurance? If so, who pays premium.

3. Customer credit risk

a) What credit terms are offered and received to related and unrelated party b) Who bears the risk of bad debts c) Is this significant risk d) What measures are taken to reduce/eliminate bad debts

4. Foreign exchange risk- It occurs when purchase of materials, resources, or services are

denominated in one currency, while sales of finished products are denominated in another currency a) Which entities are exposed to foreign exchange risk b) Is this significant risk c) Who bears the responsibility for the exposure? d) What steps are taken to reduce or eliminate exposure?

5. Inventory Risk- It relates to the losses associated with carrying finished product inventory.

Losses include obsolescence, shrinkage or market collapse, such that products are only salable at a price that produce a loss a) Does inventory become obsolete b) Who bears the cost of obsolete inventory c) How is obsolete inventory disposed of? d) Are cost recovered and reallocated.

6. Scheduling risk- This risk is assumed by a manufacturer in deciding when to make a certain

products a) How time sensitive is the manufacturing/distribution process? b) How sensitive is the product to make c) Are these significant risk d) Who bears scheduling risk, both inbound and outbound.

7. Product Technology Risk- The risk of obsolescence or stranded assets in response to

behavioral or technological change is a form of product risk. 8. Operational Risk - It relates to the physical performance of the assets operated and

managed by the business, and the scope for them to be affected by events beyond a business control.

9. Financial Risk - It relates to the relationship between the firm’s revenue and its financing costs.

10. Manpower Risk - This risk is associated with the attrition of skilled/ trained manpower which involves time and cost overruns to replace

11. Capacity Utilization Risk - This risk arises when the installed capacity for a manufacturer or service provider is not optimally utilized and the companies have to bear fixed costs associated with excess capacity.

c) Contractual Terms

The Contractual Terms generally covers the following:- i) Form of Consideration charged or paid ii) Sales and Purchase Volume iii) Warranties provided iv) Right to revision and modification v) Delivery terms vi) Credit & Payment terms 1. Explicit contractual terms of transaction may provide evidence as to the form in

which the responsibilities, risks and benefits have been assigned among parties to transaction

2. The extent to which contractual terms matter in establishing comparability will depend upon the nature of the controlled transaction and the pricing method adopted. For instance, if the controlled transaction is a license agreement and the transfer pricing method the comparable uncontrolled transaction method, information on the key contractual terms (duration, geographic area, exclusivity, etc) can be assumed critical to assess the reliability of the comparison. On the other hand, if the controlled transaction is the provision of accounting services and the comparison made with the price of similar services offered by accounting firms, details on contractual terms such as payment terms are unlikely to be of great significance.

d) Economic Circumstance of Transaction

It involves analysis of controlled transaction, Associated enterprises and comparable transaction on following aspects;-

1. Geographic location of the market 2. Market size 3. Level of the market (Wholesale or retail) 4. Competition in the market and relative position of buyers and sellers 5. Availability of substitutes 6. Government regulation of the market 7. Level of supply and demand 8. Consumer purchasing power 9. Location specific cost of production including the cost of land, labour, capital and

transportation cost 10. Economic condition of overall industry, key value driver in the industry 11. The existence of cycle (economic, business, product cycle). Where a cycle is

involved taxpayers should make an effort to explain why they believe there is a cycle, what type of cycle it is (business cycle, product cycle…), what the duration of the cycle is, where the controlled enterprise is situated in that cycle and in

what way and to what extent the cycle is expected to impact on the data to be used in different types of transfer pricing methods (i.e. price, margin, function, risk etc.)

In Skoda Auto India (P) Ltd 30 SOT 319 (Pune Tribunal), assessee was succeeded in remanding the case back to AO, mainly on the strength of ECONIMIC CIRCUMSTANCES of assesse was different from comparables.

1. The assessee, an Indian company was manufacturing and selling cars. In this very first year of its commercial production, it purchased/imported materials from its parent company and associate concerns

2. Assessee advance following arguments before Tribunal a) Assesse is new company and comparable are well established companies b) Assets and depreciation profile of assesse is sufficiently on higher side

c) Accounting policy adopted by assesse results in being technical know being written off over a period of 3 years.

d) The TPO further requisitioned the financials of the comparable relating to the periods of their incorporation and subsequent two years to prove that even they were reporting losses in that period. The assessee regretted the inability to do so as the relevant data are not in public domain. It was also submitted that the economic conditions, marketing conditions and laws pertaining to that period would be totally different vis-a-vis the conditions prevailing in the relevant period and this fact would also make the comparison meaningless. It was also submitted that in view of the technological advancements, which have huge impact on the price and profitability, it does not make sense to compare data of the assessment years in question vis-à-vis the data for a period of over a decade ago

Here explanation is appended on geographic location of Market, which includes the concept of Location Saving Geographical location of market Market prices for the transfer of the same or similar property may vary across different markets owing to cost differentials and/or differences in purchasing power and habits prevalent in the respective markets which may affect the market price . One of main feature of Geographical Location of market having repercussion on Transfer price is LOCATION SAVINGS. Locational Savings and advantages MNE may be deriving significant locational saving by shifting the enterprise from high cost location to low cost location. It may also be deriving other locational specific advantages as under:-

1. Highly specialized skilled manpower and knowledge 2. Proximity to growing local/regional market. 3. Large customer base with increased spending capacity 4. Advanced infrastructure (e.g information/communication networks, distribution

system) 5. Market Premium

It may also incurred additional cost on account of shifting to low cost country

The net benefit to MNE is called locational rent. The extent to which location specific advantages (LSA) will lead to locational rent depends on competitive factors relating to the end products and to general access to LSA. It is possible that in a particular case, even though LSAs exist, there are no location rents. For example, in situations in which the market for the end product is highly competitive and potential competitors also have access to the LSAs, much or all of the benefits of LSAs would be passed on to the customers through lower prices of products, resulting in little or no location rents. However, circumstances where extra profits are passed on to customers are varied, and may be permanent or temporary. Where this is temporary, at the end of this period of competition, the MNE may possibly achieve a larger market share in the local market with an increased ability to sell products at a higher price. Alternatively, if an MNE has exclusive access to the LSAs, then the MNE may derive significant location rents associated with the LSAs, as the LSAs reflect a competitive advantage. These location rents may dissipate over time due to competitive pressure, depending on the facts and circumstances of each case. Further arm’s length attribution of location rents depends on competitive factors relating to access to LSA and on realistic alternative available to the associated enterprise given their respective bargaining power. e) Business Strategies

Business strategies would take into account many aspects of an enterprise such as 1. Innovation and new product development 2. Degree of diversification 3. Risk Aversion 4. Impact of existing and planned labour laws 5. Duration of arrangement 6. Market share Market share strategies can be divided into 3 categories:-

1. Market penetration strategies 2. Market expansion strategies 3. Market maintenance strategies

All 3 market share strategies use two fundamental tactis;-

1. Lowering the price of products on temporary basis by offering discount on the products to become extremely competitive in the market.

2. Increasing their marketing and selling expenses through increased advertisement; sales promotion activities like offering rebates, free samples, offering extended warranties etc. and increased marketing activities like more salesmen, commission agents or distributors and increased payments of commission to distributors\

Issues involved – Marketing strategies- 1. Allocation of cost 2. Creation of marketing intangibles

Allocation of cost It is important to examine the following factors for allocation of cost between associated enterprises:-

1. Which entity is initiator of strategy 2. Which entity is intended beneficiary of the strategy 3. whether unusually intense advertising, marketing and sales promotion efforts are

taking place since these would provide a signal of market penetration or market share expansion strategies

4. The nature of the relationship between related parties, i.e. their responsibilities and risk profile

5. Whether the strategy involves intangibles 6. Which party is the legal and economic owner of such intangibles

Marketing intangibles

1. When MNE enters a new market with its product or expand market share of its product in an existing market through its subsidiary, questions of the creation of marketing intangibles and increases in the value of product‐related intangibles such as trademarks, trade names etc. follow closely behind

2. Therefore, it is quite important to examine and follow the process of creation of intangibles in a market, as well as the legal ownership of that intangible and the right to share in the return from that intangible (the notion which some countries refer to as “economic ownership”).

3. It is recognised that market research; designing or planning products suitable to market needs; advertising; marketing and sales promotion strategies; after‐sale services and networks of dealers and sales/commission agents may contribute to the creation of marketing intangibles depending on the facts and circumstances of each case

POST COMPARABILITY FACTORS ANALYSIS Analysis of 5 comparable factor should culminate in the determination of the following:-

a) Tested party- The tested party should normally be the least complex party to the controlled transaction and should be party in respect of which the most reliable and data for comparability is easily and readily available.

b) Preliminary decision on transfer Pricing Method applicable based on respective features, strengths and weakness of each of the methods.

c) Development of search criterion for identification of comparable

Here two aspects (S.No b & C) are further detailed as under:- Preliminary decision on Transfer Price Method.

Section 92C prescribed following six methods to arrive at ALP i) Comparable Uncontrolled Price Method ii) Resale Price Method iii) Cost Plus Method iv) Profit Split method v) Transactional Net Margin Profit vi) Other Method which takes into account 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 relevant facts

Each of method its own features and most suitable in particular set of circumstances The suitability of each TP methods under various scenarios are as under:-

i) Comparable uncontrolled Price Method a) One of the associated enterprises involved is engaged in comparable uncontrolled

transaction with an Independent enterprise. b) Transactions involve commodity type products, but only those in which product differences

are negligible. c) When products being transacted are commodities with relatively limited value add and have

objective quality measure that can be easily determined. d) Interest rate charged on Inter-company loan. e) Royalty

ii) Resale Price Method a) Most appropriate where tested party is engaged in pure reselling operation b) Application of RPM required that reseller does not make any material alteration to the

products traded. c) In a typical intercompany transaction involving a fully‐fledged manufacturer owning valuable

patents or other intangible properties and affiliated sales companies which purchase and resell the products to unrelated customers, the resale price method is a method to use if the CUP method is not applicable and the sales companies do not own valuable intangible properties.

iii) Cost Plus Method a) The CPM is useful for long term buy and supply agreements, pricing of semi-finished goods,

toll or contract manufacturing, services of purchasing agent, contract research and development & intra-group provision of services.

b) CPM is typically applied on controlled transactions involving a contract manufacturer which does not own product intangibles and obtains instructions from related customer about the quantity and quality to produce.

c) CPM is not suitable method to use in transaction involving a full- fledged manufacturer which owns valuable product intangible as it will be very difficult to locate independent manufacturer owning comparable product intangible

iv) Transactional Net Margin Method a) When two related parties are engaged in continuous series of transaction and one of the

parties control intangible assets for which arms length return is not easily determined b) If data on Gross margins are less reliable due to difference in the treatment of certain cost as

COGS or operating expenses between tested part and comparable company c) Where the available comparables differ significantly with respect to products and functions

in order to reliably apply the cost plus or resale price method, it may be more appropriate to apply the TNMM, because net margins are less affected by such differences. Difference in function performed may also affect the Net Margin, but still there will be similar level of Net profit indicator, if proper denominator is used. Hence TNMM may be used in this case

India’s Transfer Pricing provisions do not any hierarchy or preference for Transfer Pricing methods. But in recent judgement in Serdia Pharmaceutical, Mumbai tribunal that traditional transaction method (CPU, RPM, CPM) have an inherent edge over the traditional profit methods(PSM & TNMM) in most of the situations, and, therefore, wherever both the methods can be applied in an equally reliable manner, traditional transaction methods are to be preferred over traditional profit methods Development of Search Criterion. This stand is to further test the waters with higher judicial authority. Comparable Search Criterion In order to sustain the Transfer Study before AO, it is essential that process of identification of comparables should not be random rather based on proper criterion developed after proper FAR analysis. In order to develop, search criterion for identification of comparables, following factors should be considered:-

1. Specific Industry classification. 2. Geographic restrictions with regard to a country or region 3. Eliminate all those enterprise which may have transfer pricing issue. 4. Include or exclude specific functions such as research and development, production,

distribution and holding of shares 5. Exclude companies which are recently set up. 6. Quantitative filters with regard to Turnover. 7. Consider ratios such as turnover per employee, ratio of Net value of intangibles/Total Net

Assets value or Ratio of R&D/Sales, Manufacturing sales/Total sales, Trading sale/Total Sales, Advertising/Sales.

8. Focus on sales volume or a fixed assets or number of employees.-This will idea about the scale of operations.

9. Intangible-related criteria such as Net Value of Intangibles/Total Net Assets Value, or ratio of R&D/Sales where available: they make it possible for instance to exclude companies with significant intangibles or R&D activities when the tested party is a contract manufacturer which does not own significant manufacturing intangible nor participate in R&D

10. Criteria related to the importance of export sales (Foreign sales/total sales), when relevant

11. Criteria related to inventories in absolute or relative value: they can be used, for instance, to specifically search for manufacturers with no inventories when the taxpayer is a toll manufacturer that does not take title of inventories

6. Comparability Adjustments

Need for Comparability Adjustments

a) Transfer Price study involves comparison of conditions of Controlled transactions with uncontrolled Transaction

b) However in reality controlled and uncontrolled are not similar on every material ground. c) There arise a need to make certain adjustments in uncontrolled transaction to make is

comparable with Controlled Transaction. Further all these adjustments are made in uncontrolled transactions to make them comparable with controlled transaction.

Issues to be considered for Comparability Adjustments a) Materiality – The differences that have no material effect on comparability (Price or margin)

should not be adjusted. b) Quality of Data being adjusted – The adjustments should be carried on uncontrolled

transactions which are fairly comparable with controlled transaction, except on some aspects which can be overcome through adjustments. Too many adjustments to uncontrolled transaction may indicate that uncontrolled transaction in itself is not sufficiently comparable with controlled transaction.

c) Reliability – The adjustments should be carried out based on objective and verifiable data d) Documentation - comparability adjustments are part of comparability analysis and should

be appropriately documented in order to ensure its reliability. Among other things documentation should cover the following:- i) Reason for adjustment being considered appropriate ii) How adjustments are calculated iii) How adjustments changed the results for each comparable and how adjustments

improve comparability.

Categories of Comparability Adjustments a) Accounting adjustments b) Balance sheet Adjustments c) Functional adjustments

a) Accounting Adjustments – These type of adjustments are generally carried out, when either

of RSP, CPM or TNMM method is proposed to be used. All these method involves determination of a RATIO either Gross Margin or Net margin etc. The RATIOS are arrived on the basis of data in financial statements and these statements are based on set of accounting policies which differ from one entity to other. In order to ensure that results of two entities (Tested party and Uncontrolled party) are comparable, it is necessary that their financial statements are drawn on same set of policies. Thus based on TP method propose to be used, those accounting adjustments are carried out in uncontrolled adjustment which has material effect on ratio to be used for comparability. i) Resale Price Method –

Revenue Presentation – One entity is showing Sale expenses as deduction from sales & other entity is showing as a part of operating expenses. Revenue should be adjusted for comparability

Stock Valuation - If difference in stock valuation has material effect on GROSS MARGIN comparability , necessary adjustments are required

ii) Cost Plus Method – Ensuring the components of direct and indirect operating

expenses are on common basis and if not, necessary adjustments are required.

iii) Transactional Net Margin method – In Capgemini India (P) Ltd- ITA No. -7861/Mum/2011,A/Y – 2007-08, Mumbai Tribunal held that ESOP expenses debited in P&L was held to be extra-ordinary expense while applying TNMM method.

b) Balance sheet adjustments- These adjustments too are required when one proposed to use

either of RSM, CPM or TNMM method.

These adjustments are intended to account for different level of inventories, trade payable, trade receivable i.e working capital

A significant different level of asset intensity may require further investigation of the comparability characteristics of the potential comparable and merely making a working capital adjustment would not alleviate the problem.

Difference in level of working capital has direct repercussion on operating profitability. An entity may give more credit period to its customers but charging higher price as compared to other entity. Thus former entity having high receivable is also earning more profit as compared to latter entity. Thus it is necessary to carry our working capital adjustment to ensure comparability of tested party with uncontrolled party. Illustration - Refer below mentioned illustration in case where TNMM method is propose to use and working is done in two scenarios;- i) Where NP Margin is used as PLI ii) Where GP/Operating expense is used as PLI

c) Functional Adjustments i) There can be difference in mix of functions performed by tested party and uncontrolled

party ii) Such functional difference if not adjusted, may affect the reliability of comparable in

establishing Arm’s length price range iii) To eliminate the effect of functional difference, financial results of comparable need to

be adjusted. iv) An adjustment is made to the revenue and costs relevant to the functions performed by

the comparables but not by the tested party