1 Background
Transfer pricing
provisions in section 92 of the Income-tax Act, 1961 (‘the Act’)
prescribe that the arm’s length price (‘ALP’) of international/specified
domestic transactions between associated enterprises (‘AEs’) needs to
be determined with regard to the ALP, by applying any of the following
methods:
– Price-based methods: CUP Method
– Profit-based
methods: Resale Price Method (‘RPM’), Cost Plus Method (‘CPM’), Profit
Split Method (‘PSM’) and Transactional Net Margin Method (‘TNMM’)
– Prescribed methods: Other Method
The
provisions of the Act prescribe the choice of the Most Appropriate
Method having regard to the nature of the transaction, availability of
relevant information, possibility of making reliable adjustments, etc,
and do not prescribe an hierarchy or preference for any method1.
In
this article, the authors have sought to explain the conceptual
framework of the CUP Method, considerations for its applicability and
practical issues concerning industry-wise application of the CUP Method.
Judicial precedents have been referenced as appropriate, for further
reading.
2. Conceptual framework
The CUP Method has
been defined in Rule 10B(1)(a) of the Income-tax Rules, 1962. The
various nuances surrounding the application of CUP Method ( on the basis
of the sub clauses in the rule ) have been analysed below:
(i)“The
price charged or paid for property transferred or services provided in a
comparable uncontrolled transaction, or a number of such transactions,
is identified;”
Analysis
The CUP Method compares the
price in a controlled transaction to the price in an uncontrolled
transaction in comparable circumstances. If there is any difference in
the two prices, underlying factors remaining constant, it may suggest
that the conduct of the related parties to the transaction is not at
arm’s length, i.e. the controlled price ought to be substituted by the
uncontrolled price.
The CUP can be Internal or External. An
internal CUP is the price that the assessee has charged/paid in a
comparable uncontrolled transaction with a third party. An external CUP
is the price of a comparable uncontrolled transaction between third
parties (i.e. no involvement of the assessee). Refer to section 4 for
discussion of the issue governing selection of Internal CUPs and
External CUPs.
A potential issue could arise as regards whether
the provisions prescribe the use of a comparable ‘hypothetical
transaction’, i.e. transaction for which a price/consideration ‘is to be
paid’ or ‘would have been paid’.
Please refer to sections 5 and 6 for detailed discussions.
“(ii)
such price is adjusted to account for differences, if any, between the
international/ specified domestic transaction and the comparable
uncontrolled transactions or between the enterprises entering into such
transactions, which could materially affect the price in the open
market”
Analysis
In an ideal scenario, none of the
differences between the transactions being compared or between the
enterprises undertaking these transactions should materially affect the
price in the open market. One needs to assess whether reasonably
accurate adjustments can be made to eliminate the material effects of
such differences.
Accordingly, the application of the CUP Method
prescribes stringent comparability considerations which need to be
addressed before the determination of ALP, which makes the application
of the CUP Method extremely difficult.
Currently, there is no
prescribed guidance on the manner of computing adjustments. Accordingly,
one can take guidance from the Organisation for Economic Cooperation
and Development (‘OECD’) Guidelines which specify different types of
comparability adjustments.
The characteristics of the
goods/services/property/ intangibles under consideration, including
their end use, have a bearing on the comparability under the CUP Method
and require suitable adjustment. To illustrate, the prices of imported
unprocessed food products would not be the same as imported processed
food products.
Differences in contractual terms, i.e. credit
terms, transport terms, sales or purchase volumes, warranties,
discounts, etc., also play an important role whilst undertaking
comparability adjustments under the CUP Method and adjustments can
typically be made for these quantitative differences. Further, the
comparable uncontrolled transactions should ideally pertain to the
same/closest date, time, volume, etc., as that of the controlled
transaction.
The prices of various products may also differ due
to the differences in the geographic markets, owing to the demand and
supply conditions, income levels and consumer preferences,
transportation costs, regulatory and tax aspects, etc. Indian judicial
precedents have recognised these differences.
A potential issue
may arise in cases where it is not possible to quantify the exact
adjustment to be made to the uncontrolled transaction where the
differences are on account of qualitative attributes, say, for example,
adjustment for difference in quality of Indian products visà- vis
Chinese products.
Further, there may arise differences in the
intensity of functions performed and risks assumed by the assessee,
vis-à-vis a comparable uncontrolled transaction, where it may not be
possible to effect/adjust such differences. In such cases, it is
advisable to maintain robust transfer pricing documentation to identify
and address such material differences and reject the CUP method. To
illustrate, the ownership of intangibles such as trademarks/brands,
etc., could impair the application of the CUP Method.
“(iii) the
adjusted price arrived at under sub-clause (ii) is taken to be an arm’s
length price in respect of the property transferred or services
provided in the international/ specified domestic transaction.”
Analysis
The
results derived from an appropriate application of the CUP Method
generally ought to be the most direct and reliable measure of an ALP for
the controlled transaction. The reliability of the results derived from
the CUP Method is affected by the completeness and accuracy of the data
used and the reliability of assumptions made to apply the method.
3. Application & pertinent issues
The
Indian transfer pricing authorities have indicated a strong preference
for applying the CUP Method given that CUP directly focuses on the
international transaction under review. Even though the degree of
comparability required for application of the CUP Method is high,
unadjusted or inexact CUPs have been routinely applied by the
authorities.
Appellate Tribunals have dealt with the issue of
the application of CUP Method in several transactions pertaining to
various industry sectors and have thrown some light on the guidelines
and reasonable steps that need to be undertaken to make appropriate and
reasonable adjustments to the CUPs in order to arrive at the ALP.
Further, the Tribunals have also adjudicated on the preference of
selection of Internal CUPs over External CUPs. These industry-wide
transactions and the issues concerning application of CUP method in
regard to various categories of payments have been elucidated below:
(i) Payment/Receipt of brokerage:
Under
the internal CUP approach, the brokerage charged by the assessee
(broker) to its AEs could be compared to the brokerage charged by the
assessee to a third party. However, it would be important to consider
the following factors since they have a direct bearing on the pricing of
the respective transactions:
a. the contractual terms and conditions, i.e. underlying functions and control exercised by each transacting party (e.g. settlement terms, margin money stipulations etc.)
b. Volume of transactions and resultant discounts, if any
c. functions performed by the assessee in earning the brokerage from the related party as well as unrelated party.
The Mumbai Tribunal in the case of RBS Equities has upheld the use of the CUP method for brokerage transactions after providing for an adjustment for differences in marketing function, research functions and differences in volumes.
(ii) Payment/receipt of guarantee fees:
Placing reliance on international guidance and several judicial precedents2 , arm’s length guarantee fees are a factor of the following:
a. nature – whether the guarantee under consideration is a quasi-equity guarantee.
b. Whether the benefit derived by the recipient is implicit/ explicit in nature
c. Purpose of guarantee – A financial or unsecured guarantee would warrant a higher compensation as opposed to a performance or secured guarantee
d. the value of assets at risk/anticipated loss given default of the borrower and anticipated probability of default of the borrower
e. the rate at which guarantees are extended by banks in the country of the lender/borrower
f. Credit rating of the borrower
In view of the above, it could also be argued that guarantee rates obtained from independent bank websites are generic in nature and not specific to any particular transaction that has been carried out. thus, not only are they negotiable, they also vary depending on the terms and conditions of the transactions, and the relationship between the banks and the customer. hence, they cannot be used directly to represent the guarantee fee charged on a particular tested transaction. this principle is supported by indian judicial precedents as well.
(iii) Financial services – Intercompany loans/ deposits:
Placing reliance on several judicial precedents3, it could be argued that in a case where foreign currency loans/ deposits are advanced by an indian assessee to its overseas subsidiary (say in the USA), the rate of interest on the intercompany loan could be determined with reference to CUPs, i.e. the london interbank offered Rate plus basis points, appreciating that arm’s length interest rates are a factor of the following:
a. the value of the assets at risk, or the anticipated loss given the default of the borrower;
b. anticipated probability of default of the borrower;
c. the level of interest rates, in terms of risk-free rates for given tenor and currency;
d. the market price of risk, or credit spreads; and
e. taxes;
f. Whether the loan/deposits are quasi-equity in nature (i.e. convertible to equity upon maturity);
g. Purpose of the loan – i.e. whether the loans were extended for further investment purposes.
(iv) Pharmaceuticals, chemicals – Import of raw materials/Active Pharmaceutical Ingredients (‘APIs’):
The mumbai Bench of the indian tax tribunal, in the cases of Serdia4 Pharmaceuticals and Fulford India5, have provided useful insights on transfer pricing issues related to the pharmaceutical industry.
In the case of Serdia, the prices of off-patented APIs imported by the taxpayer from foreign aes were compared by the Revenue authorities with the prices of generic APIs purchased by competitors from third party suppliers, by using the CUP Method.
Before decoding the Serdia verdict, it would be essential to delve into the decision of the Canadian federal Court of Appeal (‘FCA’) rendered in the case of GlaxoSmithKline Inc (‘GSK’)6 , as it has been quoted and relied upon by the Tribunal in the case of Serdia.
GSK imported APIs from its AE for secondary manufacture and distribution of the drug named “Zantac”. GSK also had a license agreement with its AE, which provided GSK with the right to use the “Zantac” trademark. applying the CUP Method, the Revenue compared GSK’s import prices of APIs from AEs with the prices of generic APIs purchased by competitors from third party suppliers, and an adjustment was proposed for the difference in prices. Eventually, the FCA ruled that GSK’s license agreement with its ae must be considered as a circumstance relevant to the determination of the ALP of the APIs imported by GSK from its AE, and thereafter restored the matter back to the lower authorities for fresh adjudication.
What logically follows from the conclusion is that the price of a generic product cannot simply be a CUP for another product, which is accompanied with a license or right to use intellectual property (‘IP’), which in the aforesaid case was a valuable trademark. holding this to be the pivotal principle, let us revert to the Serdia ruling, where there was no evidence furnished by the taxpayer relating to the licensing of any accompanying intangible based on which a higher price to AEs could be justified. Further, the Tribunal clearly distinguished the facts of Serdia’s case from those in the case of uCB india7 and stated that the CUP Method cannot blindly be rejected without giving due consideration to the facts of each and every case.
Fulford, however, put forth an argument before the Mumbai Tribunal against the use of the CUP Method applied by the revenue, to benchmark the prices of import of off-patented APIs from AEs with prices of generic APIs. Fulford’s primary contention was that the said comparison was flawed, as it had been undertaken in complete disregard of the functions, assets, and risks (‘FAR’) profile or characterisation of the parties to the transaction and Fulford’s FAR was of routine distributor entitled to profits commensurate to its distribution function. Fulford argued that application of the CUP Method in such cases might result in the indian distributor earning exorbitant margins or profits, a significant portion of which it might not deserve, being related to the intangibles owned and the various risks, including product liability risks borne by the foreign principal. Another issue faced by taxpayers has been the application of the CUP Method using secret comparables. Section 133(6) of the Act empowers the Indian Revenue authorities to call for information from various public sources in order to determine the ALP of the transaction, i.e. comparing the import prices of APIs imported by the pharmaceutical companies with the prices of APIs available from such sources. In this regard, it is pertinent to note that without furnishing requisite details such as the quantum of transactions, quality of the API purchased, shelf life of the products, it is extremely difficult to make reliable adjustments as contemplated under the CUP method. A number of pharmaceutical companies face the double-edged sword where reduced import prices (owing to transfer pricing disallowances) are generally not considered by the Customs authorities for the purposes of customs duty assessment.
(v) Information technology and Software – Payment of service fee:
The charge-out rates in the case of some it companies are determined having regard to the qualification/designation of the employees, i.e. per month/per man hour rates. In this regard, some judicial precedents8 issued by the Indian Tribunals favour the application of the CUP Method as opposed to the tnmm method, since the rates are not determined on the basis of software developed or volume of work. In the case of Velankani Software, the Tribunal upheld the use of the internal CUP Method where the technology, asset and marketing support was provided by the ae in the controlled transaction as opposed to the uncontrolled transaction, where the assessee used its own technology, assets and marketing infrastructure, since the assessee operated on a billing ‘on time and material’ basis, i.e. rates based on man months at different prices for different skill sets of employees for aes as well as non aes, subject to the detailed documentation furnished by the taxpayer.
(vi) Purchase and sale of power:
It is a known fact that a number of taxpayers set up captive power production units in order to source power at economical rates and achieve synergies and long term economies of scale. for the purposes of determining the appropriate quantum of deduction under the provisions of Chapter Vi-a of the act read with section 92Ba of the act, it is essential that the transfer of power by such captive units to the operating manufacturing plants is undertaken at fair market value/ALP. In this regard, guidance is provided by recent judicial precedents9 of the tribunals, wherein it is prescribed that any of the following values could be used as a CUP to determine the FMV of the controlled transaction
a. Price at which excess power, if any, is sold by the captive power unit to the State Electricity Board
b. Price at which power is purchased by the operating companies from the State Electricity Board
c. Grid rates according to the Tariff card of the State electricity Board
(vii) Purchase and sale of diamonds:
In the diamond industry, there is a huge dissimilarity and variation of features which leads to differences in prices. the pricing of the diamonds depends upon various parameters/factors like size of the diamond, carat weight, various types of shape, colour, clarity, grade, etc., which leads to differential pricing of the diamonds. Thus, in such a condition, it becomes very difficult to apply the CUP method in benchmarking the pricing of diamonds.
4. Internal vs. External CUPs
The indian revenue authorities tend to accept the use of Internal CUPs as well as External CUPs to determine the ALP of the controlled transactions. However, the oeCd Guidelines as well as several judicial precedents10 promote the preference of the internal methods over the external methods since the assessee itself is the party to the controlled as well as the uncontrolled transaction and the quality of such data is more reliable, accurate and complete as against external comparables, which is the most important consideration in determining the possible application of the CUP Method. In case of external CUP, data may be derived from public exchanges or publicly quoted data. The external CUP data could be considered reliable if it meets the following tests:
a. the data is widely and routinely used in the ordinary course of business in the industry to negotiate prices for uncontrolled sales
b. the data derived from external sources is used to set prices in the controlled transaction in the same way it is used by uncontrolled assessees in the industry
c. the amount charged in the controlled transaction is adjusted to reflect the differences in product quality and quantity, contractual terms, market conditions, transportation costs, risks borne and other factors that affect the price that would be agreed to by uncontrolled assessees
5. Can quotations be used as CUPS?
Given the above absence of realistic internal/external CUP data for benchmarking the controlled transaction, can it be said that quotations obtained from third parties could constitute valid CUPs?
In the case of KTC Ferro Alloys Pvt. Ltd. (TS 20 ITAT 2014 (Viz) TP), Adani Wilmar Ltd. (TS 171 ITAT 2013 (Ahd) TP), Reliance Industries Ltd. (TS 368 ITAT 2012 (Mum)), Ballast Nedam Dredging (TS 25 ITAT 2013 (Mum) TP) and
A. M. Todd Co. India P. Ltd. (TS 117 ITAT 2009 (Mum)), various benches of the Tribunals had accepted quotations and rates published in magazines and newspapers as CUPs, subject to necessary adjustments.
However, in the case of Redington India Ltd. (TS 123 ITAT 2013 (CHNY) – TP), the Chennai ITAT rejected the ‘list price’ published on the manufacturer’s website as a CUP, observing that it is only an indicative price and the CUP can only be based on actual sales. Further, in Sinosteel India Pvt. Ltd. (TS 341 ITAT 2013 (DEL) TP), the Delhi ITAT held that ALP under the CUP Method is to be determined based on ‘the price charged or paid’ in a comparable uncontrolled ‘transaction’ and hence, a quotation which has not fructified into a transaction could not be accepted as a CUP.
6. Introduction of the sixth method – Other Method
The Central Board of direct taxes has inserted a new rule 10AB by notifying the “other method” apart from the five methods already prescribed:
“For the purposes of clause (f) of sub-section (1) of section 92C, the Other Method for determination of the arms’ length price in relation to an international transaction shall be any method which takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with Methods of Computation of Arm’s Length Price or between non- associated enterprises, under similar circumstances, considering all the relevant facts.”
The Guidance Note on Transfer Pricing issued by the institute of Chartered accountants of india (august 2013 – revised) explains that the introduction of the other method as the sixth method allows the use of ‘any method’ which takes into account (i) the price which has been charged or paid or (ii) would have been charged or paid for the same or similar uncontrolled transactions, with or between non-AES, under similar circumstances, considering all the relevant facts.
The various data which may possibly be used for comparability purposes under the ‘Other Method’ could be:
(a) Third party quotations; (b) Valuation reports; (c) tender/Bid documents; (d) documents relating to the negotiations; (e) Standard rate cards; (f) Commercial & economic business models; etc.
It is relevant to note that the text of rule 10aB does not describe any methodology but only provides an enabling provision to use any method that has been used or may be used to arrive at the price of a transaction undertaken between non-AEs. Hence, it provides flexibility to determine the price in complex transactions where third party comparable prices or transactions may not exist, i.e. a more lenient version of the CUP Method. The wide coverage of the other method would provide flexibility in establishing ALPs, particularly in cases where the application of the five specific methods is not possible due to reasons such as difficulties in obtaining comparable data due to uniqueness of transactions such as intangibles or business transfers, transfer of unlisted shares, sale of fixed assets, revenue allocation/splitting, guarantees provided and received, etc. however, it would be necessary to justify and document reasons for rejection of all other five methods while selecting the ‘Other Method’ as the most appropriate method. the OECD Guidelines also permit the use of any other method and state that the taxpayer retains the freedom to apply methods not described in the OECD Guidelines to establish prices, provided those prices satisfy the ALP.
The general underlying principle is that as long as the quotation can be substantiated by an actual uncontrolled transaction to be considered as a price being representative of the prevailing market price, it can be considered as a comparable under the CUP Method. For all other purposes, the quotation would be considered as a comparable under the other method.
7. Conclusion
The CUP Method is the most direct and reliable measure of an ALP for the controlled transaction, using a comparable uncontrolled transaction, subject to an adjustment for differences, if any. the reliability of the results derived from the CUP Method is affected by the completeness and accuracy of the data used and the reliability of assumptions made to apply the method.
Application of the CUP Method entails, among others, a close similarity of the following comparability parameters like quality of the product, nature of services, contractual terms and conditions, level of the market, geographic market in which the transaction takes place, date of the transaction, foreign currency risks and intangible property ownership which could materially affect the price charged in an uncontrolled transaction.
Generally, internal CUPs are preferred over external CUPs in view of availability of reliable and accurate comparable data. A quotation could be considered as a CUP, so long as it is substantiated by an actual transaction and is a clear reflection of the prevailing market price.
