Proposed Revision of Chapter I-III of
the Transfer Pricing Guidelines
Chambers of Income Tax Consultants and
International Fiscal Association
Vispi T. Patel
April 23, 2010
Agenda
Introduction
Purpose of Revision
Changes in Arm’s Length Principle
Changes in Methods
Changes in Comparability
Introduction
Last 15 years experience
Taxpayers concerned about lack of consistency as
regards interpretation of the TP Guidelines
Results in risk of double taxation, because two
administrative authorities can apply the arm’s
length standard inconsistently
Domestic law of many countries may have
nuances in their Transfer Pricing Regulations
which could be different from the TP Guidelines
Introduction …..
 Last 15 years experience (contd.)
 Thus, there is a need for the Transfer Pricing Regulations to
be more explanatory than directory or mandatory
 There is a need for the Transfer Pricing Regulations to be
more flexible to absorb the vicissitudes of business and
commerce
 There is a need to recognize that Economic forces are
dynamic and hence Transfer Pricing cannot be a rigid
standard and is thus an ‘Art’ of amalgamation of Science,
Economics and Law
Agenda
Introduction
Purpose of Revision
Changes in Arm’s Length Principle
Changes in Methods
Changes in Comparability
Purpose of Revision
 Proposed revision aims to bring more flexibility in application
of the arm’s length standard and
The Arm’s Length
Standard is based on
Comparability
Applying the Methods
To Evaluate whether controlled
transaction is at arm’s length
Purpose of Revision …..
 The proposed revision achieves this flexibility broadly by:
 Affording Transactional Profit based Methods equal status
(almost) to Transaction Based Methods
 Practical experience of the last decade and a half clearly show that
profit based methods are employed by the taxpayers and tax
administration due to lack of availability of data in public domain
at transaction level
 Broadening the section of comparability as it addresses many
concerns of the taxpayers and the tax administration
Agenda
Introduction
Purpose of Revision
Changes in Arm’s Length Principle
Changes in Methods
Changes in Comparability
Changes in Arm’s Length Principle
 There is an emphasis that at the heart of the ALP is the
comparable analysis of the conditions between the
controlled and comparable uncontrolled transactions
 Comparability is on conditions prevalent between
controlled and uncontrolled transactions including price
but not limited to price alone
 Comparable analysis will determine whether adjustment
is required to the controlled transaction or not
Changes in Arm’s Length Principle…..
 Acceptance that controlled entities may enter into transactions
which are unique and for which comparable uncontrolled
transactions may not be available, this does not imply that the
transactions are not at arm’s length
 The aim is to have a balanced approach as regards the burden of
evaluating host of comparable information and the goal is to
have reasonably reliable comparables
Agenda
Introduction
Purpose of Revision
Changes in Arm’s Length Principle
Changes in Methods
Changes in Comparability
Changes in Methods
Selection of the most appropriate transfer pricing
method to the circumstances of the case
No one method can be applied to every possible situation
The selection of a transfer pricing method always aims at
finding the most appropriate method for a particular case
Applicability of any particular method need not be disproved
Though all methods are philosophically on the same plane,
one can still feel the strong undercurrent for preference of
Traditional Transactional Methods, especially CUP
Transactional Profit Split Method –
Determination of Combined Profit to be Split
 Determination of the combined profit to be split and
splitting factors should be consistent with the
functional analysis and allocation of the risks among
the parties, based on the factors agreeable to the
independent parties, consistent with the type of profit
split approach and be capable of being measured in
reliable manner
Transactional Profit Split Method – Determination of
Combined Profit to be Split…..
 The combined profit to be split (including losses) should
only be that profit arising from the controlled
transaction(s) under review
 In order to determine the combined profit to be split,
the accounts of the parties to the transaction to which
transactional profit split is applied needs to be put on a
common basis as to accounting practice and currency,
and then combined. Accounting standards should be
selected in advance of applying the method, should be
documented and applied consistently over the lifetime of
the arrangement
Transactional Profit Split Method – How to split
the combined profit?
 The criteria or allocation keys used to split the profit
should be reasonably independent of the transfer pricing
policy formulation and should be supported reasonably
by reliable comparable data, internal data, or both
 In practice, common allocation keys are based on assets
/ capital (operating assets, fixed assets, intangible assets,
capital employed) or costs (relative spending and / or
investment in key areas such as research and
development, engineering, marketing). Other allocation
keys can be based on incremental sales, headcounts,
time spent by certain group of employees, number of
servers, data storage, floor space, etc.
Transactional Profit Split Method – How to split
the combined profit?.....
Asset base or capital based allocation can be
used where there is a strong correlation between
tangible or intangible assets or capital employed
and creation of value in context of the controlled
transaction
Cost based allocation can be used where there is
a strong correlation between relative expenses
incurred and relative value added
Transactional Profit Split Method Implications
 The revised guidance on application makes it more
practical and has a more realistic approach
 The availability of comparable data in public domain to
apply various allocation keys is the inherent limitation of
the method, which the proposed revision tries to mitigate
by even considering internal data based on FAR analysis
which accounts for contribution by the AEs
Transactional Net Margin Method –
Determination of the Net Profit Margin
 Only those items that directly or indirectly relate to
the controlled transaction at hand and are of an
operating nature should influence the
determination of the net profit margin for
application of TNMM
 Non Operating items such as income tax should be
excluded from the determination of the net profit
margin indicator. Exceptional and extraordinary
items of a non-recurring nature should generally
also should be excluded
Transactional Net Margin Method – Determination of
the Net Profit Margin…..
 Whether interest income and expenses emanate from
the operations of the enterprise and hence form part
of operating profit or not, is dependent on the
functional analysis of the enterprise and is fact driven
 Foreign Exchange Gains and Losses should be
included or excluded from determination of the net
profit margin depends upon whether they are of a
trading nature and who undertakes the forex risk
Transactional Net Margin Method – Determination of
the Net Profit Margin…..
 Whether start-up costs and termination costs should be
included in the determination of the net profit margin indicator
depends on the facts and circumstances of the case and on
whether in comparable circumstances, independent parties at
arm’s length would have agreed either for the party performing
the function to bear the start-up costs and possible termination
costs; or for part or all of these costs to be recharged with no
mark-up
Transactional Net Margin Method –
Weighing the Net Margin
 The selection of the denominator should be consistent
with the comparability (including functional) analysis of
the controlled transaction, and in particular it should
reflect the allocation of risks between the parties. Such
indicator might need to be required to be adjusted
depending on what party to the controlled transaction
bears that risk, as well as on the degree of differences in
the risk that may be found in the taxpayer’s controlled
transaction and in comparables
Transactional Net Margin Method –
Weighing the Net Margin…..
 The denominator should also be focused on relevant
indicator(s) as demonstrated by functional analysis
 The denominator should be reasonably independent of
the controlled transaction
 Denominator should be one that is capable of being
measured in a reasonably reliable and consistent
manner at the level of the taxpayer’s controlled
transaction
Transactional Net Margin Method –
Weighing the Net Margin (Indicators)
 Net Profit weighted to sales – Sometimes used to
determine the ALP of purchases from a related party for
resale to third party customers
 Net Profit weighted to costs – Should be used in cases
where costs are a relevant indicator of the functional and
economic business model of the tested party. The cost
base used should be a reflection of the controlled
transactions that are evaluated
Transactional Net Margin Method – Weighing the
Net Margin (Indicators)…..
 Net Profit weighted to assets – Return on assets can be an
appropriate base in cases where assets (rather than cost or
sales) are a better indicator of the value added and risk
undertaken by the tested party
 Berry Ratios – Defined as ratios of gross profit to operating
expenses. Interest and extraneous income would be included
depending upon the nature of the business; depreciation and
amortization may or may not be included in the operating
expenses, depending in particular on the possibilities of
uncertainties they can create in relation to valuation and
comparability
Transactional Net Margin Method Implications
The detailed guidance on application of TNMM
will be a practical aid for the taxpayer and the
tax administration
The importance of the determination of the
profit to be tested is critical
Transactional Net Margin Method –
Implications…..
 The application of TNMM is founded on comparing
profitability ratios of comparable uncontrolled transactions
with that of the controlled transactions, hence the correct
selection and application of the ratios is of utmost importance
 The economic analysis and the business model would
determine the methodology of margin computation and the
nuance of pass-through costs used in TP analysis has been
correctly recognized
Agenda
Introduction
Purpose of Revision
Changes in Arm’s Length Principle
Changes in Methods
Changes in Comparability
Comparability Analysis
While selection of a cost plus, resale price or
transactional net margin method, it is necessary to
choose the party to the transaction for which the
financial indicator is tested. The choice of the
tested party should be consistent with the
functional analysis of the transaction. The tested
party is the one to which has the least complex
functional analysis
Comparability Analysis…..
 The complete search process identifying potentially
comparable uncontrolled transactions and their link
to the functional analysis and to the ultimate
conclusion of the benchmarking process is at the
very heart of the TP analysis and consequently in
determining the ALP
 Profit based methods should in no case cast an
additional burden merely because the enterprise is
less successful and conversely successful enterprises
should not be charged less tax, as success or lack
thereof is based on economic and commercial factors
and not on TP analysis alone
Comparable Uncontrolled Transactions
 A comparable uncontrolled transaction is a transaction between
two unrelated parties that is comparable to the controlled
transaction under examination. It can either be internal
comparable or external comparable.
 Comparison of the taxpayer’s controlled transactions with such
other controlled transactions are irrelevant to the application of
the arm’s length principle and therefore should not be used by a
tax administration as the basis for the transfer pricing adjustment
or by the taxpayer to support its transfer pricing policy
 Use of commercial database for identifying external comparable
uncontrolled transactions should not encourage quantity over
quality
Comparability Adjustments
 The most commonly observed adjustments, especially
while using the transactional net margin method, are
balance sheet or asset intensity adjustments. Other type
of adjustment including accounting adjustment that are
aimed at dealing with differences in accounting
standards or classification of income and expenses;
adjustments for differences in contractual terms, etc.
 Comparability adjustments should be considered where
(and only where) they can be expected to increase the
reliability of the results
Comparability Adjustments…..
 Data from years following the year of the transaction may
also be relevant to the analysis of transfer prices, but care
must be taken to avoid the use of hindsight
 Examining multiple year data is often useful in
comparability analysis, but it is not a systematic
requirement. Multiple year data should be used where it
adds value to the transfer pricing analysis
Vispi T. Patel & Associates
#10, Dwarka Ashish, Jambul Wadi,
Opp. Edward Cinema, Kalbadevi
Road,
Marine Lines, Mumbai – 400 002
Contact No.: +91 22 2208 4605 / 7742
+91 98676 35555
Thank You
Email: vispitpatel@vispitpatel.com
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