ARM’S LENGTH PRICE DETERMINATION
WITH REFERENCE TO FAR ANALYSIS
Neeraj K. Jain, FCA
Vaish Associates
INTRODUCTION:
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.
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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……….”
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“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
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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, t raining and
personnel management services.
(2)
Contractual Terms: A comparison of significant contractual terms is
required in comparing controlled and uncontrolled transaction. The Regulations
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specify seven nonexclusive contractual terms that could affect the comparability
of the controlled and uncontrolled transactions –
i)
ii)
iii)
iv)
v)
vi)
vii)
(3)
the form of consideration charged or paid;
sales or purchase volume;
the scope and terms of warranties;
rights to updates, revisions or modifications;
the duration of relevant license, contract or other agreements, and
termination or renegotiation rights;
collateral transactions or ongoing business relationships between
the buyer and seller, including arrangements for the provision of
ancillary services; and
the extension of credit and payment terms.
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)
ii)
iii)
iv)
v)
vi)
(4)
market risks, including fluctuations in cost, demand, pricing and
inventory levels;
risks associated with R&D;
financial risks (including currency and interest rate risk);
credit and collection risks;
product liability risks and
general business risks related to the ownership of property, plant
and equipment.
Economic Conditions: The US Regulations identify eight significant
economic conditions that can affect prices or profits:
i)
ii)
iii)
iv)
v)
vi)
vii)
viii)
(5)
the similarity of geographic markets;
the relative size of each market and its level of economic
development;
the level of the market;
the applicable market shares for the relevant products, properties
or services;
the location-specific costs of production and distribution;
the extent of competition in each market for the relevant products
or services;
the economic condition of the particular industry and
the alternatives realistically available to the buyer and seller.
Property or Services: Finally, determining the comparability of
controlled and uncontrolled transactions requires a comparison of the property or
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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).
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Contract manufacturers
Does not own technology
Little risk
Purchasing
Little discretion in production
scheduling
Does not totally control equipment
Scheduling
Quality control usually dictated
-
Fully-fledged manufacturers
Owns technology
Full of risk
Production scheduling
Select own equipment scheduling
Direct control over quality by
customer
- Usually manufacturing high volume, Manufacturing products at all high
high volume mature products
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
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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.
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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-
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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 comparable s 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
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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.
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