The fast growth in the technology, communication and transportation has led to a number of multinational national enterprises (MNEs) having the flexibility to conduct their operations through enterprises set up anywhere in the world. This has given rise to significant global trade such as international transfer of goods and services, capital, intangibles within the entities in the MNE. The MNE group’s transaction structure is determined by a combination of market forces, group policies which could differ from open market conditions operating in independent entities. In such a scenario it becomes important to establish appropriate ‘transfer price’ for the transactions within the MNE group.
2. Introduction
Internationally “arm’s length principle” or the “arm’s length price” has been accepted as a benchmark for establishing transfer price for intercompany transactions. The arm’s length principle is based on ‘separate entity approach” wherein each entity is regarded as a separate entity in the group. Arm’s length principle applies to transactions between related parties i.e. the associated enterprises (AE). Each country has prescribed various criteria’s to determine the AE relationship. Different transfer pricing methods have been prescribed for implementation of the arm’s length principle and the same can be applied by both the taxpayers and the tax authorities to determine the appropriate arm’s length price. While the OECD guidelines1, UN Manual2 and the approaches followed across various jurisdictions provide guidance on the various methods adopted, however, the evolving business practices and the indigenous methods adopted by the companies make it imperative to bring about harmonisation of the methods applied in line with the changing business and commercial environment.
The Indian transfer pricing regulations have recognized six methods which can be applied by the tax payers to demonstrate the arm’s length price of the international transactions. Earlier under the OECD guidelines, the Transactional profit methods were to be resorted to only when the traditional transaction methods could not be reliably applied alone or exceptionally could not be applied at all. Now the transactional profit methods (namely TNMM and PSM) have been accorded status of an acceptable method of transfer pricing. The Indian TP regulations follows the “most appropriate method” principle to demonstrate the arm’s length principle, whereby the tax payer has to test all the methods in order to select the most appropriate method that justifies the arm’s length measure for the international transactions. PSM is also one of the methods that have been prescribed in the Indian TP Regulations.
In the ensuing paragraphs discussion is focused on PSM:
3. Transaction Profit Split Method
3.1 History
The PSM, wherein the arm’s length price is determined through division of consolidated profits between the members of the group, has had a long history in terms of actual use by both the taxpayers and tax authorities. In the 1979 OECD Guidelines, PSM was excluded as an acceptable arm’s length pricing method, although reference to profit allocations based on proportionate contribution to final profit in the said guidelines can be implied as allowance of this approach. However in the 1995 version of the OECD Guidelines, PSM was included as second best option to the traditional transaction based methods. Across the OECD delegates there was been reluctance to accept PSM as an apt method to determine arm’s length price as there was lack in well articulated economic theory or practical experience justifying the application of the method in specific transactions or application of global formulary apportionment3. Nevertheless, PSM when correctly applied offers an important alternative to the traditional one sided transactional or profit based valuation approaches and it addresses the exceptional bilateral aspects of certain transactions while being in compliance with the arm’s length principle.
3.2 Concept
The OECD guidelines define PSM as “A transactional profit method that identifies the combined profit to be split for the associated enterprises from a controlled transaction …. And then splits those profits between the associated enterprises based upon an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an agreement made at arm’s length.”
The PSM seeks to eliminate the effect on profits of special conditions made or imposed in controlled transaction (or in controlled transactions that it is appropriate to aggregate) by determining the division of profits that independent enterprises would have expected to realise from engaging in the transaction or transactions.
The PSM first identifies the profits (i.e. combined profits) to be split between the associated enterprises from the controlled transactions in which the associated enterprises are engaged. The said combined profits are then split on an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an agreement made at arm’s length.
The PSM is generally applied when there is significant contribution of intangible property by the parties of the controlled transactions.
3.3 PSM under the Indian TP Regulations
The Indian Transfer pricing Regulations are covered in Chapter X of the Income-tax Act, 1961 (‘the Act’). Section 92C of the Act has provided PSM as one of the methods to determine the arm’s length price of the international transaction. Further, Rule 10B(1)(d) of the Income tax Rules, 1962 (‘the Rules’) provides guidance on the identification and application of PSM.
The Indian TP Regulations provide that PSM is mainly applicable to the following transactions:
(a) International transaction involving transfer of unique intangibles or in circumstances where two or more enterprises perform functions which involves unique or valuable contributions.
(b) In multiple international transactions which are so interrelated that they cannot be evaluated separately for the purpose of determining the arm’s length price of any one transaction.
It is clear that PSM cannot be a most appropriate method where the transactions employ only routine functions and comparables can be found. PSM is the most appropriate method only when the operations involve high integration.
For the purpose of determining the arm’s length price under the PSM, the following steps are required:
(a) Determination of the combined net profit of the AEs arising from the international transaction in which they are engaged.
(b) E valuation of the relative contribution made by each of the AE to the earning of such combined net profit on the basis of the following:
a. functions performed, assets employed or to be employed and risks assumed by each enterprise; and,
b. reliable external market data which indicate how such contribution would be evaluated by unrelated enterprises performing comparable functions in similar circumstances.
(c) The combined net profit is then split amongst the enterprises in proportion to their relative contributions, as evaluated in (b) above;
(d) The profit thus apportioned to the taxpayer is taken into account to arrive at an arm’s length price in relation to the international transaction.
The indian TP regulations also provide that the combined net profit referred to in sub-Clause (a) may, in the first instance, be partially allocated to each AE so as to provide it with a basic return appropriate for the type of international transaction in which it is engaged, with reference to market returns achieved for similar types of transactions by independent enterprises and thereafter, the residual net profit remaining after such allocation may be split amongst the aes in proportion to their relative contribution in the manner specified under sub-Clauses (b) and (c). In such a case the aggregate of the net profit allocated to the AE in the first instance together with the residual net profit apportioned to that AE on the basis of its relative contribution shall be taken to be net profit arising to that enterprise from the international transaction.
3.4 Approaches for splitting profits
For the purpose of splitting the profits to determine the arm’s length price under PSM, generally following two approaches namely contribution analysis and residual analysis are considered. The said approaches are not necessarily exhaustive or mutually exhaustive.
(a) Contribution analysis – under the contribution analysis, the combined profits from the controlled transactions are allocated between the aes on the basis of the relative values of the functions performed, assets employed and risk assumed by each of the ae engaged in the controlled transaction. External market data that reflects how the independent enterprises allocate the profits in similar circumstances should supplement the analysis to the extent possible. The profit so apportioned is used to arrive at the arm’s length price in relation to the international transaction. The said profit of the AE when added to the costs incurred in relation to the international transaction would result in arm’s length price.
Contribution analysis may apply to various circumstances and various techniques apply to a contribution analysis. these techniques endeavor to evaluate quantitatively the contribution of each party to the transaction. Some of the techniques applied globally are discussed below:
i. Capital investment approach – The said approach consists of assessing the relative contribution of the parties to the transaction based on the capital invested in the intangibles by both parties. For determining the basis for profit split, reliance is placed on the economic relationship between the capitals invested by the parties to the transaction. Investment includes investment in intangible capital and operating profits. For applying this technique, it would be relevant that the intangibles as well as the economic owners of such capital are well defined. Also, it is necessary to have an indepth understanding of the circumstances relating to the transaction. This technique can be applied to cases where the expenditures building up the capital can provide a realistic picture of the contribution made by the parties to the transaction.
ii. Compensation approach – Under this technique the labour cost data (including salary, fringe benefits, bonuses, etc.) of each party is taken into consideration to determine the contribution towards the transaction. Once the labour costs of one party are collated they are captialised in order to capture the amount of time required to build the corresponding intangible asset. The assumption for taking into consideration the labour cost data is that it is a representative of the economic value to the company created by an employee. The principle underlying this technique is in line with the “significant people function” concept discussed in the OECD report on the “Attribution of profits to permanent establishment Part i (december 2006). This technique can be adopted only in a scenario where labour resources are critical value drivers for the transaction. This technique requires specific attention as it is based on an indepth understanding of the market/ industry, group’s value chain and key drivers, the nature of the functions/roles and responsibilities of the persons, related costs which are the basis for the assessment of the contribution.
iii. Bargaining theory approach – Under this technique, the bargaining positions of each of the parties to the transactions are analysed to assess the contribution made. Bargaining theory if used effectively could be a powerful tool to determine the contribution of each party as it evaluates the roles of each party and thereby the corresponding function towards adding value to the transaction.
iv. Survey approach – This technique is adopted when identification of the internal and external data to be considered for determining the contribution is not possible. under this approach, opinions on the assumptions for splitting the profits are obtained from both inside and outside the company. the key challenge of this approach is the identification of the internal and external experts whose opinions have to be considered and also the compilation of the set of questions that would be relevant. Statistical tools can be employed to analyse the opinions sought from the internal and external experts to arrive at a numerical valuation. This approach to be effective requires robust documentation of the opinions, survey design and the survey answers.
In applying the contribution analysis, the above techniques can be effective tools in quantifying the contribution of the group entities in the transaction. In most cases, a conjunction of these techniques could allow determining the appropriate arm’s length pricing for the transaction.
(b) Residual analysis – under the residual analysis, the combined profits from controlled transactions are allocated between AEs based on two step approach:
a. Step 1: depending on the functions performed, assets employed and risks assumed, the basic return appropriate to the respective ae is determined. The combined profit is allocated on this basis which results in partial allocation of the combined net profits to each AE.
b. Step 2: The residual profits is allocated on the basis of an analysis of the facts and circumstances (reference can be made to contribution analysis).
The said profit of the AE when added to the costs incurred in relation to the international transaction would result in arm’s length price.
In practice, generally residual analysis is adopted more as compared to contribution analysis. This is so as the residual analysis is a two step process wherein the first step determines a basic return for routine functions based on comparables and the second step analyses returns to unique intangible assets based not on comparables but on relative value. Further, the possible dispute before the tax administration is reduced as the profits to be attributed based on relative value post the first step is reduced.
Comparable Profit Split Method (CPSM)
In some countries, a different version namely CPSM of PSM is applied. Here, the profit is split by comparing the allocation of operating profits between the AES to the allocation of operating profits between independent enterprises participating in similar circumstance. The Indian Regulations also hint at comparable profit split method. however, the tribunal in one of the recent ruling in the case of Global one india Private Limited (discussed later) has held that mandatory direction in the rules to mandatorily use the comparable PSM to split profits would make the PSM redundant in most case as obtaining relevant market data on third party for splitting profits would be difficult.
Contribution analysis and CPSM are different as CPSM depends on availability of external market data to directly measure the relative value of contribution, while the contribution analysis can be applied even if such a direct measurement is not available. However, both contribution analysis and CPSM are difficult to apply in practice as the reliable external market data required to split the combined profits are often not available.
3.5 Identification of key value drivers – robust functional analysis
Functional analysis is of prime importance in the arm’s length principle. Functional analysis identifies the significant functions performed, assets employed and risks assumed by the parties to the controlled arrangement. it assists in assessing the values of the contributions of the parties in the controlled arrangement. The functions that need to be identified and compared includes design, manufacturing, assembling, research and development, servicing, purchasing, distribution, marketing, advertising, transportation, financing and management. The types of assets used to be considered includes plant and machinery, use of valuable intangibles, financial assets, etc. and also the nature of the assets used needs to be considered such as the age, market value, location, property right protections available etc. further, the functional analysis has to consider the material risks assumed by the parties as the assumption and allocation of risk would influence the conditions of the transactions between the ae. The risks to be considered could include market risks, such as input cost and output price fluctuations; risks of loss associated with the investment in and use of property, plant and equipment, risks of the success or failure of investment in research and development, financial risks such as caused by currency exchange rate and interest rate variability, credit risks, etc.
Robust functional analysis assists in identifying the key value drivers of each party to the transactions thereby highlighting where the value is created.
3.6 Methodology to split profits – relevant factors
It is imperative that the arm’s length allocation of the combined or residual profits is resultant of robust functional analysis and knowledge of the entire trade of the parties to the transaction and the profits made by the said parties. The OECD guidelines recommend approximating as closely as possible the split of profits that would have been realised had the parties been independent enterprises.
Some of the methods and the factors impacting the profit split are discussed below:
Methods:
3.6.1 Reliance on data from comparable uncontrolled transactions
Here, the splitting of profits is based on the division of profits actually arising from comparable uncontrolled transactions. Instances of sources of information on uncontrolled transactions that could assist determination of mechanism to split profits based on facts and circumstances includes joint venture arrangements between independent parties, development projects in the oil and gas industry, arrangements between independent music record labels, uncontrolled arrangements in financial services sector, etc.
3.6.2 Allocation keys
Splitting of profits can be achieved using appropriate allocation keys. Based on the facts and circumstances of the case, the allocation keys can be fixed or variable. In a scenario where there are more than one allocation key used, then it is necessary to weight the allocation keys used in order to determine the relative contribution that each allocation key represents to the earning of the combined profits. The key requirement being that the allocation keys used to split the profits should be based on objective data and supported by comparables data or internal data or both.
Generally used allocation keys are based on assets/ capital (operating assets, fixed assets, intangible assets, capital employed) or costs (relative spending on key areas such as marketing, r&d, etc.). Other allocation keys based on incremental sales, headcounts, time spent by and salary costs of certain set of people for the creation of the combined profits, etc.
Asset/capital based allocation keys can be used where there is strong correlation between tangible or intangible assets or capital employed and creation of value in the context of controlled transaction.
Cost based allocation key i.e. allocation based on expenses can be used where it is possible to identify a strong correlation between relative expenses incurred and relative value added. Cost based allocation is simplistic. however, cost based allocations are sensitive to the accounting classification of the costs. Hence, it becomes pertinent to select the costs that will be taken into consideration for the purpose of determining the allocation key consistently among the parties to the controlled transaction.
3.6.3 Assignment of weights
Here, the profits are split between the relevant entities by assigning of weights to the relative contributions of the parties involved against the value drivers created from the transactions. However, assignment of weights to the value drivers would be subjective. the process of assigning weights can be backed up by conducting interviews with the employees of both the parties, analysis of the industry, etc in order to determine the weights to be assigned to the value drivers. regression analysis can also be adopted to estimate the relative contribution of the value drivers in enhancing the profits.
3.6.4 Bargaining capacity
Under this approach, the outcome of the bargaining between independent enterprises in the open market can be the criteria to allocate the residual profits. This is a two step approach. In the first step, post the determination of the combined profits, the lowest price available in the open market should be given to the entities involved in the transaction. thereafter, the highest price available that the buyer is willing to pay should be estimated. The difference between such highest and the lowest price should be considered as the residual profit. In the second step, the residual profit should be allocated amongst the entities involved in the transaction on the basis of how the independent enterprises would have split the said differential profits.
however, this approach has not seen much practical application in india.
Factors impacting profit split
3.6.5 Timing Issues
Timing is an important aspect that needs to be factored while determining the relevant period from which the elements of determination of the allocation keys is based. Difficulty could be on account of the time gap between the incurring of the expenses and time when the value is created. Also, in certain instances, it could be difficult to identify which period’s expenses are to be considered. This determination is of prime importance in order to appropriately allocate the profits between the parties to the controlled transactions based on the facts and circumstances of the case.
3.6.6 Estimation of projected profits
In a scenario where PSm is applied by the ae to determine the transfer price in controlled transactions, then each AE would have to achieve the profits that independent enterprise would have expected to realize in similar circumstances. Generally, such transfer prices would be based upon projected profits rather than actual profits as it would not be possible for the taxpayers to know what the profits of the business activity would be at the time of establishing the transfer price. When the tax authority analyses the application of PSM to assess if the method has reliably established the arm’s length transfer price then it is critical to acknowledge that the tax payer at the point of establishing the transfer price would not have known the actual profit of the business activity. In such a scenario the application of PSm would be contrary to the arm’s length principle because the independent parties in similar circumstances would have only relied on projections.
3.7 Example of PSM under the residual profit split approach
Facts of the case
a. FCO is engaged in manufacturing and selling of semiconductor products. It developed an original semiconductor and holds the patent for the manufacturing technology.
b. FCO has an overseas subsidiary ICO which is engaged in developing and manufacturing digital equipment using the new semiconductors as well as additional technology developed by itself.
c. Company ICO is the only manufacturer licensed by FCO to manufacture the new semiconductor.
d. FCO purchases all of the digital equipment manufactured by ICO and sells them to third parties.
Key aspect of the transaction
Both FCO and ICO contribute to the success of the digital equipment through their design of the semiconductor and the equipment. The key driver of the transaction is the technology. The products are very advanced in technology and unique in design and concept.
Independent comparables with similar profile or intangible assets could not be obtained due to the uniqueness of the transaction. Therefore, none of the methods being CUP, CPM or TNMM could be considered as the ‘most appropriate method’ in this case. Accordingly, PSM was considered as the most appropriate method.
Upon screening of various external data sources, the group is able to obtain reliable data on digital equipment contract manufacturers and its wholesalers. However, upon analysis it was noted that these manufacturers and wholesalers did not own any unique intangibles. Comparable external data revealed that the manufacturers ordinarily earn a mark-up of 10% while the wholesalers derive a 25% margin on sales.
Application of PSM
Step 1 – Determining the basic return
|
Particulars |
ICo |
FCo |
|
Sales |
125 |
150 |
|
Cost |
85 |
125 |
|
Gross margin |
40 |
25 |
|
Less |
5 |
15 |
|
operating margin |
35 |
10 |
The simplified accounts of FCO and ICO are as under:
The total operating profit for the group is $ 45 (35+10)
Calculation of returns for contract manufacturer function
ICO (Contract Manufacturer)
|
Cost of goods sold |
$ 85 |
|
Margins |
10% |
|
Cost mark-up of ICO |
(10% x 85) 8.5 |
|
Transfer |
$ 93.50 |
FCO (intangible owner)
|
Sales to third party customers |
$ 150 |
|
Resale |
25% |
|
Resale margin (or gross margin) |
$ 37.50 |
Computation of basic return based on comparables (without intangibles)
|
Particulars |
ICo (in $) |
FCo (in $) |
|
Sales |
93.5 |
|
|
Cost |
85 |
|
|
Gross margin |
8.5 |
37.5 |
|
Operating |
5 |
15 |
|
Routine operating margin |
3.5 |
22.5 |
The total Routine operating margin of the group is $ 26.
Step 2: Dividing the residual profit
The residual profit of the group is Operating Profit – routine operating margins given to both entities = $45 –
$26 = $19
Identifying intangibles (i.e. key value drivers): detailed analysis of the two companies demonstrated that two particular expense items namely r&d expenses and marketing expenses are key intangibles critical to the success of the digital equipment.
the r&d expenses and marketing expenses incurred by each company are (assumed):
FCO $12 (80%)
ICO $ 3 (20%)
Assuming that the r&d and marketing expenses are equally significant in contributing to the residual profits, based on the proportionate expenses incurred:
FCO’s share of residual profit (80% x 19) $15.20 ICO’s share of residual profit (20% x 19) $ 3.80
Apportionment of adjusted profit Therefore, the adjusted operating profit of FCO is = $22.50 + $15.20 = $37.70
ICO is = $3.50 + $3.80 = $7.30
The adjusted tax accounts are as follows:
|
Particulars |
ICo |
FCo (in $) |
|
Sales |
97.3 |
150 |
|
Cost |
85 |
97.3 |
|
Gross margin |
12.3 |
52.7 |
|
Sales, |
5 |
15 |
|
operating margin |
7.3 |
37.7 |
hence, the transfer price for iCo sales to fCo determined using the residual analysis approach should be $97.30.
Key factors to be considered for PSM
(a) robust far analysis is basis on which the contribution of the parties to the key value drivers of the transaction would be determined
(b) in depth knowledge of industry is necessary in deciding on the key value drivers
(c) detailed discussion with the personnel of the parties to the international transaction would be crucial in concluding on the key value drivers and the weights that could be assigned based on the contribution of each party to the transaction.
3.8 Practical difficulties when applying PSM
Application of PSM could pose certain difficulties which could restrict the determination of the combined profits for the purpose of allocation amongst the enterprises involved in the transactions.
Some of the practical difficulties are mentioned below:
(a) ascertaining the basis to split that is economically valid could be a difficulty that the AE could face.
(b) disaggregating the controlled transaction in a case of highly integrated transactions could be difficult considering the levels of integration within the group entities.
(c) availability of external comparables for valuation of intangibles and other unique contributions could pose challenges.
.
3.9 Strengths and weaknesses
3.9.1 PSM includes the following strengths:
? offers solution for highly integrated operations for which one-sided method would not be appropriate. also appropriate to transactions where both parties make unique and valuable contributions to the transaction.
? Best suited for transactions where the traditional methods prove inappropriate due to lack of comparable transactions.
? Offers flexibility by taking into account specific, possibly unique, facts and circumstances of the associated enterprises that are not present in independent enterprises while still constituting an arm’s length approach to the extent that it reflects what independent enterprises would have done under same circumstances.
? application of this method does not result in either party to the controlled transaction being left with an extreme and improbable profit result as both the parties to the transaction are evaluated.
? able to deal with returns to synergies between intangible assets or profits arising from economies of scale.
3.9.2 PSM includes the following weaknesses:
? Splitting of residual profits under the residual analysis on the basis of relative value is weak considering the assumption that synergy value is divided pro rata to the relative value of the inputs.
? Dependency on access to data from foreign affiliates to determine the combined profits. Difficulty to the aes and tax administrators to obtain information from foreign affiliates.
? Difficulty in ascertaining the combined revenues and costs for all the associated enterprises taking part in the controlled transactions due to difference in accounting practices. also allocation of the costs to the controlled transaction vis-à-vis other activities of the aes would be difficult.
3.10 Indian tax authorities views on certain transactions
3.10.1 Captive research and development centers
India’s pool of scientific and engineering talent has attracted several global corporations to set up research and development (r&d) centers in india. these set ups generally operate as a limited risk captive center being compensated on a cost plus mark-up basis by their overseas parent companies. The influx of such centers has generated employment opportunities, large scale capital investment in state of art facilities and made path for cutting edge technologies. However, the indian tax authorities have challenged the business models and pricing mechanisms adopted by such centers and have resorted to attributing higher compensation for the r&d activities performed by indian entity. The higher margins applied by the tax authorities has stirred dispute and uncertainty amongst the key players in this sector.
The rangachary committee was set up by the indian Government to make recommendation on the transfer pricingissues faced by r&d centers. The said committee’s report prompted the Central Board of direct taxes (CBDT) to issue following circulars with an aim to provide certainty on such issues:
(a) Circular No. 2 of 2013 – made the application of PSM almost mandatory for determining the profits attributable to the r&d centers especially those which perform r&d activity involving generation and transfer of unique tangibles or engaged in multiple and highly integrated international transactions.
(b) Circular No. 3 of 2013 – prescribed certain conditions on fulfillment of which the R&D centers could be treated as entities bearing insignificant risks and would not be required to apply PSM.
The said circulars was not accepted by the taxpayers and based on various representations made by the stakeholders the CBDT rescinded Circular no. 2 to state there were hierarchy of methods and that PSm was preferred method to determine arm’s length price of intangibles or multiple inter-related transactions. Further Circular no. 6 was introduced in place of erstwhile Circular No. 3. The circular also classified R&D centres into following 3 categories:
? Centres which are entrepreneurial in nature
? Centres based on cost sharing arrangements
? Centres which undertake minimal insignificant risks in the r&d activities in india.
The amended circulars 3 and 6 states that PSm is not the most appropriate method for the r&d centers with insignificant risks bearing and that TNMM can be applied for determining the arm’s length .
3.10.2 Location savings
Location savings refers to the cost savings in a low cost jurisdictions like india are instrumental in increasing the profits of the parent companies. The Indian tax authorities are of the view that such savings should be factored while determining the arm’s length price for the indian entity. Accordingly, the tax authorities have proposed high mark- ups for captive iteS/ it sectors.
The tax authorities are of the opinion that in addition to the operational advantages leading to location savings, India offers location specific advantages (LSA) such as highly specialised and skilled manpower and knowledge, access and proximity to growing markets, large consumer base, etc. The incremental profit from LSA is known as location rents. The tax authorities have acknowledged that an arm’s length compensation should factor an appropriate split of cost savings between the parties. Hence, the tax authorities recommend profit split method as most appropriate method to determine the arm’s length compensation for cost savings and location rents between the parties.
3.10.3 Investment banking
By nature the investment banking transactions are complex, integrated and require contributions from different locations within the group to co-ordinate and interact with each other to complete a transaction and deliver efficient solutions to the client. The services cannot be easily segregated and accordingly assignment of fees towards each of the service is a difficult proposition.
Over the years, india’s role has evolved from being a support service provider providing routine services like back-office and administration to performing high end functions like origination, underwriting and execution. Accordingly, the indian investment banking companies have to adopt global pricing policies followed at group level. the Global policy generally provides for an allocation of income/revenue of the group to various group entities. It reflects the factor approach discussed in the Guidelines on Global trading discussed in the oeCd report on the Attribution of Profits to Permanent Establishments.
Considering that the investment banking operations are highly integrated and also involve contributions by various group entities, PSM could be considered as the most appropriate method. However, since the policies of investment banking call for split of gross revenues or split of revenues on a deal by deal basis, as such they do not strictly fall under the PSM according to the indian transfer pricing regulations. However, the other method (i.e. sixth method notified) could be evaluated for this purpose.
3.11 Indian judicial precedence
Global One India Private Limited vs. ACIT [TS-115- ITAT-2014(Del)
The PSm prescribed in the indian TP regulations is quite unique as compared to the OECD guidelines and UN TP manual. While the OECD Guidelines and the un TP Manual allow flexibility to the taxpayer to adopt any of the sub methods namely – contribution PSM, residual PSM or comparable PSM, the indian TP regulations require the residual/contribution PSM to be substantiated by comparable PSM.
The tribunal observed that allocation based on benchmarking with external uncontrolled transactions would result in impossibility of application as it is not possible to obtain comparables for allocating residual profits. Further, the Tribunal observed that the prescription in the rules to mandatorily use the comparable PSM to split profits would make the PSM redundant in most case as obtaining relevant market data on third party for splitting profits would be difficult. Such data would be available in cases of joint venture arrangements.
The tribunal in this landmark ruling held that residual PSM was the most appropriate method. By placing reliance on the OECD Guidelines, UN TP manual and US TP regulations, the Tribunal held that the residual profits should be allocated based on relative value of each enterprises contribution.
The tribunal also accepted that if the PSM applied by the taxpayer did not fit within the definition of PSM then the same could be considered as the ‘other method’ as provided in rule 10AB of the rules. The tribunal observed that the ‘other method’ applicable retrospectively, was introduced with the intention of enabling the determination of the arm’s length price for cases where prescribed methods posed practical difficulty in application.
ITO vs. Net Freight (India) Pvt. Ltd.[TS-363-ITAT- 2013(DEL)-TP]
The application of the PSm under the indian tP regulations is detailed in rules 10B and 10C. the tribunal in this ruling explained the application of PSm based on the guidance provided in rule 10B(1)(d) and observed the following:
• A plain reading of the Rule 10(b)(1)(d) demonstrates that PSm is applicable mainly in international transactions – (a) involving transfer of unique intangibles; (b) in multiple international transactions which are so interrelated that they cannot be evaluated separately.
• Under the transfer pricing rules described the assessee can adopt either contribution PSM, where the entire system profits are split among the various aes swho are parties to the transaction in question or residual PSM, where each of the aes who are parties to the transaction in question are first assigned routine basic returns for the routine functions performed by the, and there after the residual profits are split among the AES.
Aztek Software (TS-4-ITAT-2007(Bang)-TP)
In special bench ruling the application of PSm was explained in detail. The Tribunal observed that the profits needs to be split among the associated enterprises on the basis of reliable external market data, which indicates how the unrelated parties have split the profits in similar circumstances. Further, the tribunal held that for practical application, benchmarking with reliable external market data is to be done in case of residual PSM, at the first stage, where the combined net profits are partially allocated to each enterprise so as to provide it with an appropriate base return keeping in view the nature of the transaction. The residual profits may be split as per the relative contribution of the associated enterprise. also, for splitting the residuary profits a scientific basis for allocation may be applied.
3.12 Conclusion
The PSM has recently become more acceptable as an appropriate method and the revenue authorities are applying the method more frequently to determine the arm’s length price of controlled transactions. Correctly structured application of PSm is fully consistent with arm’s length economies and the separate enterprise standard. however, application of multiple methods as a corroborative to evaluate the arm’s length result of the most appropriate method has found place in practice. PSM can be used along with one or more transfer pricing methods to arrive at an arm’s length result. it is of importance to note that PSm as a method brings out principles on how to split profits among the AEs involved in the transaction, however it is a question whether under the domestic laws the adjusted profits (post allocation) should be taxed or not. Given the current complexity of the transactions and evolving business atmosphere, flexibility in application of methods is of utmost importance in order to determine the arm’s length pricing and arrive at firm and robust solution to the group.
