Transactional Net Margin Method – Overview and Analysis

Under transfer pricing, the transaction (controlled transaction) between the taxpayer and its associated enterprise or related party, as the case may be, has to be at Arm’s Length Price (‘ALP) i.e. the price at which the independent parties would have entered into the same or similar transaction under similar circumstances. The Chapter II of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (‘OECD guidelines’) prescribe the following methods in order to determine the arm’s length price of the controlled transaction:

The old OECD hierarchy of methods suggested that the CUP method was the most preferred, next came the other “traditional transactional” methods (resale price and cost plus) followed, in “exceptional” cases where the first three methods cannot reliably be applied, by the profit based methods (the transactional net margin method and profit split). Profit based methods were described as ‘methods of last resort’. This distinction is now removed. The basis for choosing one method over the others is now expressed as “finding the most appropriate method for a particular case”. Nevertheless, it is clear that some sort of comparison is required and that the basis for that comparison includes the availability and reliability of the comparable data that can be used when applying any particular method.

In line with the OECD guidelines, the Indian Transfer Pricing Regulations (‘TPR’) provides that the arm’s length price of an international transactions and specified domestic transactions is to be determined by adopting any one of the above methods, being most appropriate (i.e. the method which provides the most reliable measure of the arm’s length price considering the facts and circumstances in each case). However, in addition to above, the Central Board of Direct Taxes (‘CBDT’) under the Indian TPR has prescribed such other method which tests the arm’s length price of the controlled transaction with reference to the price which has been charged or paid for the same or similar uncontrolled transaction under similar circumstances.

2. Conceptual framework

Mechanism to apply TNMM has been mentioned Rule 10B(1)(e) of the Income Tax Rules, 1962 as under:

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

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

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

(iv) the net profit margin realised by the enterprise and referred to in sub-clause (i) is established to be the same as the net profit margin referred to in sub-clause (iii); (v) the net profit margin thus established is then taken into account to arrive at an arm’s length price in relation to the international transaction.”

TNMM is applied with an objective to examine the ratio of net profit in relation to an appropriate base (e.g., costs, sales, assets) that a taxpayer realises from a controlled transaction. In the event where such uncontrolled transaction of the taxpayer are not available, net profit relative to identical base realised by unrelated enterprises from comparable uncontrolled transaction is determined. The net profit of taxpayers under controlled transaction is compared either with net profit margins of taxpayer under uncontrolled transaction or with the net profit margins of unrelated enterprises from comparable uncontrolled transactions after making appropriate adjustments, if any. The net profit margin earned under uncontrolled transactions after necessary adjustments, if any is considered as arm’s length margin in respect of the international transaction or specified domestic transaction.

TNMM does not require strict product and functional comparability as is required in case of traditional methods such as CUP, RPM and CPM. The TNMM primarily focuses on comparison of net profit margin realised by the associated enterprises in their controlled transactions with that of uncontrolled transactions. Typical transactions where TNMM can be applied are provision of services, distribution of finished products where RPM cannot be applied, transfer of semi-finished goods where CPM cannot be applied, transactions involving intangibles where PSM cannot be used, etc.

TNMM is generally the preferred method amongst the taxpayers and the tax authorities. However, the manner of applying TNMM is often seen as cause of dispute in most of the practical cases. More often there exists difference of opinion between taxpayers and the revenue authorities in respect of considering the TNMM as the most appropriate method against the traditional methods. For example, practically in most of the cases of a distributor having import transactions from related parties for onward distribution in the Indian market, while the taxpayers select RPM for benchmarking such international transactions, the tax authorities select TNMM as the most appropriate method. Further, application of CUP method/CPM over TNMM or vice versa is often seen as a matter of disputes during transfer pricing audits in India.

3. Application of TNMM, pertinent issues and few judicial rulings

The steps involved in application of TNMM are as under:

Each of the above steps on application of TNMM, practical difficulties/challenges during the transfer pricing audits in India and few of the judicial rulings are briefly described as under:

Step 1: Selection of the tested party
When applying TNMM, it is necessary to choose the party to the transaction for which a financial indicator (mark-up on costs, gross margin, or net profit indicator) is tested. As a general rule, the tested party is the one to which a transfer pricing method can be applied in the most reliable manner and for which the most reliable comparables can be found, i.e., it will most often be the one that has the less complex functional analysis. However this has been an area of litigation during transfer pricing audits in India. The revenue authorities and the tax payers have divergent views on selection of tested party i.e., whether tested party should be Indian tax payers or foreign Associated Enterprise (AE). Selection of foreign comparables is also one of the area where litigation subsists during transfer pricing audits in India.

Judicial Rulings:

However diverse are the judicial pronouncements supporting selection of foreign AE as a tested party, including Development Consultants P. Ltd. vs. DCIT [2008] 115 TTJ 577 (Kol), Mastek Ltd. vs. ACIT [2012]
53 SOT 111 (Ahd.), AIA Engineering Ltd. vs. ACIT [2012] 50 SOT 134 (Ahd.), Global Vantedge Private Limited vs. DCIT  (2010-TIOL-  24-ITAT-DEL),  General  Motors India P. Ltd. vs. DCIT [ITA nos. 3096/Ahd 2010  and  3308/ Ahd 2011.], the outcome of said Tribunal rulings are in accordance with the international best practices with regards to selection of tested party. It has been settled  in these rulings that tested party should be the least complex entity for which reliable data in respect of itself and in respect of comparables is available. In such cases it was held that the tested party could be the local entity or a foreign AE. Such rulings gave credence to the fact that the foreign AE can also be selected as a tested party depending upon the facts and circumstances of the case.

Step 2: Selection of data for comparison
The Indian TPR requires that the arm’s length analysis be based on data for the relevant financial year only.

While applying TNMM, one of the conflicts prevails where the taxpayers are required to maintain contemporaneous documentation i.e. documentation should exist before the Form 3CEB is filed. As per the Income-tax rules, the data to be used for arm’s length analysis has to be for the relevant financial year under consideration. However, as has been experienced till date, the data for comparable companies (in case where external TNMM using search process from databases is preferred) for the arm’s  length analysis in respect of the relevant financial year  is generally not available before the Form 3CEB is filed due to search database limitations. This leads to need for usage of multiple year data in order to undertake arm’s length analysis. Internationally also, multiple year data analysis is considered as it takes into account relevant economic factors like business cycles etc., which may impact the determination of arm’s length price.

Judicial Rulings:
Practically it has been noticed that the India tax authorities do not consider multiple year data analysis and proceed to perform the TNMM analysis using single year data i.e. the data related to financial year under consideration. There are host of rulings against the taxpayers disregarding the usage of multiple year data including Aztec Software and Technology vs. ACIT (294 ITR 32, Bang ITAT), Symantec Software Solutions Pvt. Ltd vs. ACIT (ITAT No. 7894/ MUM/2010, etc.

However, contrary to the above rulings, the jurisdictional Bangalore Income Tax Appellate Tribunal in the case of Phillips Software Centre Private Limited (ITA No. 218/ Bang/2008) has held that the TPO cannot use data during assessment that was not available to the assessee at the time of preparation of documentation. Further, the Hon’ble Delhi Tribunal in case of Panasonic India Private Limited vs. Income Tax Officer (ITA No.1417/Del/2008) held that proviso to Rule 10B(4) would allow the taxpayer to adopt the previous two year’s average PLI along with the current year’s PLI of the tested party and on a similar footing allow the taxpayer to adopt the three year’s average PLI of comparable companies.

The above practical difficulty should be now resolved   by the recent amendment in the Finance Act, 2014. It was proposed in the Budget Speech of 2014 by the Hon’ble Central Finance Minister that use of multiple year data (instead of single year data) would be allowed for comparability analysis. However, the detailed rules in this regard would be notified subsequently.

Step 3: Aggregation of transactions
While computing profits under TNMM, the international transactions in relation to a particular activity which are subject to transfer pricing are aggregated and the net profit for the activity is arrived for benchmarking with   the uncontrolled transaction. While, the Indian TPR is silent on the aggregation of transactions, the principles on aggregation of transactions are contained in the OECD guidelines. For example, consider as case where there are multiple sales transaction entered by an India taxpayer, being a manufacturer to its various group companies located in different parts of the world. Due to inherent practicalities of determining net profits earned by the taxpayer in respect of each of such sales transactions, it is more often seen that all the sales transactions are ‘aggregated’ and the net profit of the taxpayer arising  out of its manufacturing activities is benchmarked as a separate ‘class of transaction’.

Further, practically it is seen that while applying TNMM, all the international transactions are aggregated and entity wide net profit is determined for benchmarking purpose. For example consider a scenario  where  a  taxpayer  has entered into multiple  international  transactions such as sales from manufacturing activities, sales from distribution activities, payment of royalty, payment of corporate charges, interest payments, etc. It is seen that in many cases, all the transactions are aggregated and net profit of the taxpayer is determined and compared  for benchmarking analysis. However, as per the various judicial pronouncements it is well settled that each and every transaction needs to be benchmarked separately taking into consideration the functions performed, assets employed and risks assumed (typically called as FAR analysis) under each of such transactions.

Aggregation  and  segmentation  is  often   challenged by the income tax authorities. Appropriate level of segmentation of the taxpayer’s financial data is needed while determining the  net  profits  of  the  taxpayers  from controlled transaction. Therefore, it would be inappropriate to apply TNMM on a company-wide basis if the company engages in a variety of different controlled transactions that cannot be appropriately compared on an aggregate basis with those of an independent enterprise. Similarly, when analysing the transactions between the independent enterprises to the extent they are needed, profits attributable to transactions that are not similar to the controlled transactions under examination based on the FAR  analysis should be excluded for the purpose   of comparison.

Practically, there are numerous cases wherein while making the transfer pricing adjustments, the tax authorities have applied TNMM on overall entitywide basis instead of restricting the adjustments to international transactions only. The TNMM analysis should be restricted only to the international transaction.

Judicial Rulings:
The issue related to the principle of aggregation of transaction  vis-a-vis  segmentation  of  transactions  and restriction of transfer pricing adjustment to the international transactions only is covered under various ITAT rulings such as Aztec Software and Technology vs
.ACIT, (294 ITR 32 – Bang ITAT); Ranbaxy Laboratories Ltd vs. ACIT (299 ITR 175 – Del ITAT), M/s Panasonic India Pvt Ltd vs. Income Tax Officer (2010) TII-47-ITAT- DEL-TP; UCB India Private Ltd. vs. ACIT (reference: ITA No. 428 & 429 of 2007); DCIT vs. M/s Starlite (reference: ITA No. 2279/Mum/06), Birlasoft (India) Limited vs. DCIT [TS-227-ITAT-2014(DEL)-TP]; Tecnimont ICB Pvt. Ltd. [TS-251-ITAT-2013(Mum)-TP],etc.

Application of TNMM on aggregated basis in case where unique intangibles are involved:

In certain cases, comparability analysis could be difficult where the transactions include unique intangibles. Following extracts from the OECD  guidelines  deals  with a typical case where the transaction involves sale  of branded products and difficulty that could arise in determining ALP of the transaction.

“6.25 For example, it may be the case that a branded athletic shoe transferred in a controlled transaction is comparable to an athletic shoe transferred under a different brand name in an uncontrolled transaction both in terms of the quality and specification of the shoe itself and also in terms of the consumer acceptability and other characteristics of the brand name in that market. Where such a comparison is not possible, some help also may be found, if adequate evidence is available, by comparing the volume of sales and the prices chargeable and profits realised for trademarked goods with those for similar goods that do not carry the trademark. It therefore may be possible to use sales of unbranded products as comparable transactions to sales of branded products that are otherwise comparables, but only to the extent that adjustments can be made to account for any value added by the trademark. For example, branded athletic shoe “A” may be comparable to an unbranded shoe in all respects (after adjustments) except for the brand name itself. In such a case, the premium attributable to the brand might be determined by comparing an unbranded shoe with different features, transferred in an uncontrolled transaction, to its branded equivalent, also transferred in an uncontrolled transaction. Then it may be possible to use this information as an aid in determining the price of branded shoe “A”, although adjustments may be necessary for the effect of the difference in features on the value of the brand. However, adjustments may be particularly difficult where a trademarked product has a dominant market position such that the generic product is in essence trading in a different market, particularly where sophisticated products are involved.”

Application of TNMM is such cases could be more useful as the net margins are less affected and are more tolerant to product differences and other conditions prevailing in case of controlled transactions vis-a-vis uncontrolled comparable transactions.

Further, practically let us consider an example in case  of a Manufacturing concern, say A Ltd. There are sales by A Ltd. to its various group companies and also there are royalty payments to a group company towards use  of brand, technical know-how, etc. The ideal approach would be to benchmark the sales transactions and royalty payment transaction separately. However, quite often due to practical difficulties related to availability of comparability of data etc., separate benchmarking of such transactions becomes difficult. To counter such scenario, TNMM is generally applied on an aggregate entitywide basis, wherein net profit from a “class of transactions” i.e. Manufacturing sales is benchmarked using comparable data either internally or using external database with appropriate adjustments, if any.

Step 4: Identification of comparables
Comparable analysis is the essence of Transfer pricing and that too while applying TNMM. Under TNMM, the comparable analysis is required at broad functional level based on the FAR analysis. For example, comparables can be chosen depending upon broad category of business i.e., trading function, manufacturing function, service function etc. The comparables (uncontrolled transaction) typically can be internal comparable or external comparables.

TNMM should ideally be established by  reference  to the net profit indicator  that  the  same  taxpayer  earns in comparable uncontrolled transactions, i.e., by reference to “internal comparables” Where the internal comparables are not available, the net margin that would have been earned in comparable transactions by an independent enterprise (“external comparables”) may serve as a guide. A functional analysis of the controlled and uncontrolled transactions is required to determine whether the transactions are comparable and what adjustments may be necessary to obtain reliable results.

External comparables are found out using publicly available databases. Prowess (a database developed by Centre for Monitoring Indian Economy Private Limited) and CapitalinePlus (a database developed by Capital Market Publishers India Private Limited) are  widely  used amongst the taxpayers and transfer pricing authorities in India.

The OECD guidelines specifies the use internal TNMM over external TNMM. However, the controversy in respect of the same subsists between the taxpayer and the revenue authorities. Internal TNMM has been considered to be preferable by the Indian appellate tax authorities. While the internal TNMM is more preferred choice, it is not applied due to lack of comparable data. Further while applying external TNMM over database, there are host of differences on the manner of selection of comparable companies – commonly called as “search process”. There are continual disputes between taxpayers and tax authorities on selection of appropriate search filters. For example the prominent disagreements over quantitative filters could be application of minimum/maximum sales turnover (for example considering software giants like Infosys, Wipro etc., having huge turnover while comparing with pygmies software players), filter for service revenue over total revenue, export sales filter, employee cost to total sales filter, filter on related party transactions, etc.

Further, as we understand that in practical world no company can have its exactly comparable company with same functionalities; application of TNMM sometimes becomes a challenging task for taxpayers as well as tax authorities. Therefore qualitative analysis under TNMM more often fails to reach consensus between tax payers and tax authorities on identification of ‘ideal’ comparables.

Judicial Rulings:
The various judicial rulings placed emphasise on selection of comparable companies considering the Functions, Assets and Risk (FAR) analysis of the controlled transactions vis-a-vis uncontrolled transactions. The few important rulings include Mentor Graphics (P) Ltd. vs. DCIT (112 TTJ 408, 2007 18 SOT 76, 109 ITD 101 – Delhi
ITAT), UCB India Private Limited vs. ACIT [2009-TIOL- 184-ITAT-MUM, (2009) 30 SOT 95)], DCIT vs. Quark Systems (P) Ltd. (2010-TIOL-31-ITAT-CHDSB), etc.

Step 5: Selection of suitable PLI
The application of TNMM requires the selection of an appropriate PLI. The PLI measures the relationship between (i) profits and (ii) either costs incurred, revenues earned, or assets employed.

In applying the TNMM, an appropriate PLI needs to be selected considering a number of factors, including the nature of the activities of the tested party, the reliability  of the available data with respect to the comparable companies, and the extent to which the PLI is likely to produce an appropriate measure of an arm’s length result.

A variety of PLIs can be used. TNMM aims at arriving   at the arm’s length operating profit (i.e., profit before financial and non-operating expenses).  The  examples of PLI commonly used while applying TNMM are net operating profit/total operating cost (OP/TC), net operating profit/total sales (OP/Sales), net operating profit on total assets employed (return on assets), net operating profit on capital employed (return on capital employed), berry ratio (i.e. ratio of gross profit over operating value added expenses), etc.

Determination of the appropriate base while choosing PLI: The denominator of a PLI should be focused on the relevant indicator(s) of the value of the functions performed by the tested party in the transaction under review, taking account of its assets used and risks assumed. For instance, capital- intensive activities such as certain manufacturing activities may involve significant investment risk, even in those cases where the operational risks (such as market risks or inventory risks) might be limited. Where a transactional net margin method is applied to such cases, the investment- related risks are reflected in the net profit indicator if the latter is a return on investment (e.g. return on assets or return on capital employed).

The denominator should be reasonably independent from controlled transactions; otherwise there would be no objective starting point. For instance, when analysing a transaction consisting in the purchase of goods by a distributor from an associated enterprise for resale to independent customers, one could not weight the net profit indicator against the cost of goods sold because these costs are the controlled costs for which consistency with the arm’s length principle is being tested. Similarly, for a controlled transaction consisting in the provision    of services to an associated enterprise, one could not weight the net profit indicator against the revenue from the sale of services because these are the controlled sales for which consistency with the arm’s length principle is being tested.

During the transfer pricing audits, the selection of appropriate PLI is one of the disputed issues. For example, in case where the taxpayers has imports as well as export transactions with its AEs. In such an event, selection of PLI i.e. OP/cost, OP/sales or berry ratio could be a debatable issue. The transfer pricing authorities typically do not accept usage of PLI such as return on assets or return on capital employed disregarding the functional profiles, nature of industry and other critical business or economic reasons. Usage of Berry ratio in case of typical limited risk distributors or service provider is quite often not considered appropriate by the transfer pricing authorities in India.

Judicial Rulings:
Various judicial rulings in dealt with the aspect of PLI selection, few of important ones being Schefenacker Motherson Ltd vs. DCIT [123 TTJ 509 (Del)], Kyungshin Industrial Motherson Limited vs. DCIT, New Delhi [2010-TII-61-ITAT-DEL-TP], etc.

Step 6: Economic adjustments, if any
The Indian TPR provides that the net profit margin should be adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, which could materially affect the amount of net profit margin in the open market. Typical comparability adjustments while applying TNMM are working capital adjustments, market risk adjustment, capacity utilisation adjustments, etc. However, in absence of concrete guidance on manner of carrying out such adjustment workings under the Indian TPR, practically   it becomes difficult for the taxpayers to convince the tax authorities on veracity of such adjustments. However, in case of working capital adjustments, guidance is more often taken from OECD guidelines on mechanisms to carry our such adjustments and this is too some extent accepted by the Transfer Pricing authorities in India.

Judicial Rulings:
There are multiple judicial rulings on economic adjustments while applying TNMM. The rulings dealt with allowance of working capital adjustments, capacity utilisation adjustments, adjustments due to accounting policies (depreciation charge), etc. The important ones being Mentor Graphics (P) Ltd. vs.  DCIT  [112  TTJ  408, 2007 18 SOT 76, 109 ITD 101 (Del ITAT)], E-gain
Communication (P) ltd. vs. ITO [118 TTJ 354, 23 SOT 385 (Pune ITAT)], Philips Software Centre Pvt. Ltd. vs. ACIT [2008-TIOL-471-ITAT-BANG], TO vs. CRM Services India
(P) Ltd., CRM Services India (P) Ltd. vs. ITO [ITA No. 4796(Del)/2010,ITA No. 4796(Del)/2010], etc.

Step 7: Assessment of profit for comparisons
As a matter of principle, only those items that (a) directly or indirectly relate to the controlled transaction at hand and (b) are of an operating nature are taken into account in the determination of the net profit indicator for the application of the TNMM. However, in a practical scenario, there are many controversies in the treatment of revenue items into operating or non-operating. For example, treatment of foreign exchange fluctuations, bad debts, provision for bad debt, amortisation of goodwill, etc. as operating/non-operating items. The assessment of profit depends upon appropriate selection of cost base and    in absence of appropriate guidance and host of diverse judicial pronouncements, practical difficulty in applying TNMM still prevails.

Judicial Rulings:
In absence of any guidelines as to what should form  part of “operating costs”/”operating revenue” while determining “operating net profit” for TNMM application is debatable under the Indian transfer pricing regime. The various judicial pronouncements in India dealt with the issue related to computation of net profits of the tested party and comparable companies in  order  to  assess the arm’s length price. The prominent rulings being Schefenacker Motherson Ltd. vs. DCIT [123 TTJ 509 – Delhi ITAT], Chrys Capital Investment Advisors India Pvt. Ltd. [2010-TII-11-ITAT-Delhi-TP], Sap Labs India Private Limited vs. ACIT Bangalore [2010-TII-44-ITAT-BANG-TP], DHL Express India Pvt. Ltd. [TS-353-ITAT-2011(Mum)], Trilogy E business Software India Pvt. Ltd. [TS-455-ITAT- 2011(Bang)],etc.

Step 8: Determination of the arm’s length price
In order to apply the arm’s length principle, sometimes it is possible to test the same with a single uncontrolled price/ margin. However, transfer pricing is not an exact science and therefore, in most of the cases, application of the most appropriate method results in a range of prices/margin which are comparable to the controlled transaction. In such cases, as provided under the Indian TPR, the arm’s length price must be determined considering the average mean of such range of prices/margin.

The Indian TPR also provides that the average mean as mentioned above can be adjusted by +/- 1% in case of wholesale traders and 3% in case of others to fit in the arm’s length principle.

Judicial Rulings:
There are judicial rulings such as Mentor Graphics (P) Ltd. vs. DCIT [112 TTJ 408, 2007 18 SOT 76, 109 ITD 101 – Del ITAT], ACIT vs. MSS India Pvt. Ltd. [123 TTJ
657 2009-TIOL-416-ITAT-PUNE], etc. on the principles on determination of arm’s length price.

Summary of few judicial rulings on each of the above aspect related to application of TNMM is enclosed as Annexure 1.

4.    advantages and limitations of applying the TNMM

5.    revised chapters i-iii of the OECD guidelines

The erstwhile OECD guidelines included five comparability factors – characteristics of property or services, functional analysis, contractual terms, economic circumstances and business strategy. Under the revised OECD guidelines, while the said comparability factors are still applicable, revised Chapter III of the OECD guidelines sets out a ten-step process for performing a comparability analysis. Application of the steps is stated as being “good practice” and is not compulsory “as reliability of the outcome is more important than the process”. The ten steps, which are not necessarily sequential, are:-

?    Broad based analysis of the taxpayer’s circumstances;
?    Determination of years to be covered;
?    Functional analysis;
?    Review of existing internal comparables;
?    Determination of available sources of information on external comparables;
?    Selection of the most appropriate transfer pricing method;
?    Identification of the potential comparables;
?    Determination of and making appropriate comparability adjustments where appropriate;
?    Interpretation and use of data collected; and
?    Implementation of the support processes.

In terms of comparability adjustments, the revised OECD guidelines suggests the basis of undertaking or not undertaking adjustments to the comparables and tested party and concludes that, if possible, adjustments must be made where differences exist, which could materially affect the comparison. The revised OECD guidelines also state that where internal comparables exist, it may not be necessary to search for external comparables. However, it also recognises that internal comparables are not always necessarily a more reliable basis for evaluating arm’s length nature of transaction between taxpayer and related party.

The revised OECD  guidelines  reinforces  that  TNMM  is unlikely to be reliable if both parties to a transaction contribute unique intangibles. Where TNMM is applicable, the OECD guidelines provides guidance on the comparability standard to be applied, reinforcing the importance of determining an appropriate profit level indicator as the basis of the analysis and discussing the importance of undertaking adjustments so that interest and foreign exchange income and expenses are treated in a comparable manner in the profit level indicator of both the tested party and the comparables. Annexure I to Chapter II of the revised OECD guidelines has laid down certain numerical illustrations on sensitivity of gross and net profit indicators.

Illustrations on sensitivity of gross and Net Profit Margins Due To Functional Differences

llustration 1 – Difference in functional and risk profile of distributors:

Enterprises  performing  different  functions  may  have  a wide range of gross profit margins while still earning broadly similar levels of net profits. For instance, TNMM would be less sensitive to differences in volume, extent and complexity of functions and operating expenses.

Let us consider an example of a distributor, say X Ltd. importing certain goods from its group companies for further distribution in India. X Ltd. performs significant marketing function and bears product obsolescence risk. Also let us assume that there is another distributor, say Y Ltd. importing similar goods from its group companies for further distribution in India. The import price for X Ltd. and Y Ltd. for the goods would be different in view of difference in the functions and risk borne by each of them. The import price in case of X Ltd. should typically be lower than that of import price in case of Y Ltd. The gross profits of X Ltd. and Y Ltd. would be influenced by such functional differences. However, TNMM is more tolerant to such functional differences. This can be explained by way of numeric illustration as under:

(*) Assume that in this case the difference of INR 100    in transaction price corresponds to the difference in the extent and complexity of the marketing function performed by the distributor and the difference in the allocation of the obsolescence risk between the manufacturer and the distributor.

From the above table, it can be observed that the risk   of error at gross margin level would amount to INR 100 (10% x 1,000), while it would amount to INR 20 (2% x 1,000) if a TNMM was applied.

This illustrates the fact that, depending on the circumstances of the case and in particular of the effect of the functional differences on the cost structure and on the revenue of the “comparables”, net profit margins can be less sensitive than gross margins to differences in the extent and complexity of functions.

Illustration    2    –    Effect    of    a    difference    in manufacturers’ capacity utilisation:
 
In certain scenario TNMM may be more sensitive than the cost plus or resale price methods to differences in capacity utilisation, because differences in the levels of absorption of indirect fixed costs (e.g. fixed manufacturing costs or fixed distribution costs) would affect the net profit but may not affect the gross margin or gross mark-up on costs if not reflected in price differences. Let us consider an example where P Ltd. a manufacturer of certain goods operates in full capacity (say 1000 units per year) vis-a- vis. Q Ltd., a manufacturer of similar goods which operates at a lesser capacity of what it could manufacture in full year (say 800 units per year in case where full capacity is 1000 units).

case and in particular on the proportion of fixed and variable costs and on whether it is the taxpayer or the “comparable” which is in an over-capacity situation.

In addition to above, the OECD guidelines have under Annexure to Chapter III has provided an example of a working capital adjustment typically undertaken while applying TNMM.

6.    Conclusion

TNMM does not require stringent comparability norms (product comparability, exact functional comparability, etc.) unlike in case of other prescribed transfer pricing methods like  CUP, RPM,  CPM  and  PSM.  Therefore  it can be noticed that TNMM is generally the preferred method amongst the taxpayers and transfer pricing authorities in India. (*) This assumes that the arm’s length price of
 
However, the TNMM has its own practical difficulties and nuances explained above. As discussed, over a decade old Indian transfer pricing regime has witnessed significant number of judicial rulings  relating  to  various  aspects on application of TNMM. This include aspects such as preference of other transfer pricing methods over TNMM, selection of tested party, selection of comparable period, choosing appropriate PLIs, segmentation vs. aggregation of transactions, selection of comparable companies, application of appropriate search filters, validation of transfer pricing adjustments, determination of appropriate cost base while applying TNMM,  etc.  Such  difference of opinion between the taxpayers and transfer pricing authorities on application of TNMM has led to disputes and controversies during transfer pricing audits in India. Reference on ten step process of comparability analysis under the revised OECD guidelines and numerical examples on sensitivity of gross and net profit indictors
 
The manufactured products is not affected by the manufacturer’s capacity utilisation.

From the above table it can be observed that the risk of error when applying at gross margin level could amount to 16 (2% x 800) instead of 50 (5% x 1000) if TNMM is applied.

This illustrates the fact that net profit indicators can be more sensitive than gross mark-ups or gross margins to differences in the capacity utilisation, depending on the facts and circumstances of the

Under typical circumstances could serve as guiding factor for applying TNMM under the Indian Transfer Pricing context.

Thus, in view of above, the need for hour in the Indian transfer pricing regime is to reinforce certain regulatory framework and lay out concrete guidelines on application of TNMM and mitigate the practical challenges on application of TNMM as the most appropriate method. This will certainly help in resolving perpetual uncertainty, hardship and never ending litigation for the taxpayers and transfer pricing authorities in India.

Annexure 1 – Few Judicial rulings on various aspects related To application of TNMM:
1.    selection of tested party:

2.    selection of data for comparison:

3. aggregation of transactions vs. segmentation:

4. Identification of comparables:

5.    selection of PLI:

6. economic adjustments:

7. Assessment of profits for comparison:

8.    Determination of arm’s length price: