Where,
• TP = the transfer price of a product sold between a sales company and a related company;
• RSP = the resale price at which a product is sold by a sales company to unrelated customers; and
GPM = the Gross Profit Margin that a specific sales company should earn, defined as the ratio of gross profit to net sales. Gross Profit is defined as Net sales minus cost of goods sold.
2.4 Most suitable situations for applicability of RPM:
The applicability of the method depends upon the facts of each case. However, various commentaries like OECD and UN has laid down situations where RPM would most likely be the suitable option in order to determine the arm’s length price. The same has been discussed in the ensuing paragraphs.
If comparable uncontrolled transactions can be identified, the CUP method may very well be the most direct and sound method to apply the Arm’s Length Principle. If the CUP method cannot be applied, however, other traditional transaction methods to consider are the Cost Plus Method and the Resale Price Method.
In a typical intercompany transaction involving a full-fledged manufacturer owning valuable patents or other intangible properties and affiliated sales companies which purchase and resell the products to unrelated customers, the resale price method is a method to use if the CUP method is not applicable and the sales companies do not own valuable intangible properties.
The situations where RPM could apply are discussed below:
The OECD guidelines states that RPM can be used where the reseller does not add substantial value to the products. Thus the reseller should add relatively little or no value to the goods. It may be difficult to apply RPM where goods are further processed and identity of goods purchased from AE is lost. For example, let say a reseller is doing limited enhancements such as packaging, repacking, labelling etc. In this case, this sort of activities does not add significant value to the goods and hence RPM could be used for determining ALP.
However, significant value addition through physical modification such as converting rough diamonds into cut and polished diamonds adds significant value to the goods and hence, RPM cannot be applied for such value added activity.
Another example could be, say, mineral water is imported from AE and sold in the local market by adding the brand name of Indian company, RPM cannot be applied since there is significant addition in value of goods due to the use of brand name of Indian company.
A Resale Price Margin is more accurate where there is shorter time gap between purchase and sale. The more time that elapses between the original purchase and resale the more likely it is that other factors like changes in the market, in rates of exchange, in costs, etc, would affect the price and hence would also be required to be considered for comparability analysis.
Further, in RPM the comparability is at the gross margin level and hence, RPM requires a high degree of functionality comparability rather than product comparability. Hence, a detailed analysis showing the close functional comparability and the risk profile of the tested party and comparables should be clearly brought out in the Transfer Pricing study report in order to justify comparability at gross profit level under RPM. Thus, RPM is useful when the companies are performing the similar functions.
However, a minor difference in products is acceptable if they are less likely to have an effect on the Gross Profit Margin. For example, Gross Profit Margin earned from trading of microwave ovens in controlled transaction can be compared with the Gross Profit Margin earned by unrelated parties from trading in toasters since both are consumer durables and fall within the same industry.
2.5 Steps in application of RPM:
Identify the transaction of purchase of property or services;
Identify the price at which such property or services are resold or provided to an unrelated party (resale price);
Identify the normal Gross Profit Margin in a comparable uncontrolled transaction;
Deduct the normal gross profit from the resale price;
Deduct expenses incurred in connection with the purchase of goods;
Adjust the resultant amount for the functional and other differences such as accounting practices etc that would materially affect the Gross Profit Margin in the open market;
The price arrived at is the Arm’s Length Price of the transaction.
The application of the resale price method can be understood with the following example:
The international transaction entered into by AE1 Ltd. with AE2 Ltd. which should be determined on the basis of Arm’s Length Price.
In another uncontrolled transaction, AE1 Ltd. had purchased from unrelated supplier (K Ltd.) and sold to unrelated customer (M Ltd.) and earned Gross Profit Margin of 15%.
The differences in sale to K Ltd. and A Ltd. are on account of the following:
Sale to A Ltd. was ex-shop and sale to M Ltd. was FOB basis. This accounted for additional 2% difference in Gross Profit Margin as sales price increased but corresponding expenses are not debited to trading but profit and loss account.
Quantity discount was provided to A ltd and not M Ltd. Impact is 1% on GP margin.
The differences in purchase from AE2 and K Ltd. are as follows:
Additional freight expenses incurred of Rs. 10 per unit and quantity discount received of Rs. 15 per unit on purchases from AE2 ltd and not on purchases from K Ltd. Further, Rs. 25/- towards custom duty is incurred on purchases in both the cases.
2.6 Advantages and Challenges of the RPM:
Advantages of RPM
The method is based on the resale price i.e., a market price and thus represent demand driven method
The method can be used without forcing distributors to in appropriately make profits. Hence, unlike other methods, distributor could incur losses on net basis due to huge selling expenses even if there is an Arm’s Length Gross Margin. Hence, this method could be used without distorting the figures.
Challenges of RPM
Non availability of gross margin data of comparable companies from public database is the biggest challenge in applying RPM since Companies Act, 1956 does not require Gross Profit Margin calculation to be reported and Tax Audit Reports which contain Gross
Profit Margin are not available in public database. Hence, difficulty would arise on account of external comparables.
Differential accounting policies followed across the globe makes application of RPM very difficult. Example:
Some companies include exchange loss/gain in purchase/sale whereas some companies show it as part of administrative and other expenses. Example
Some companies include excise duty on purchase in Purchase A/c whereas some companies show it as part of rent, rates and taxes.
RPM is unlikely to give accurate result if there is difference in level of market, function performed or product sold. Further, due to lack of availability of information on functions performed by the comparables, comparing the level of functions is difficult.
Another disadvantage is, for certain industries such as Pharmaceutical industry, wherein it is difficult to identify companies exclusively performing trading operations as most of the companies are into manufacturing and trading.
Further, usage of RPM in case of services could be a challenge considering the difference of surrounding situations in service transactions vs. product transactions as well as the financial disclosure norms applicable for service entities.
2.7 RPM – Comparability Parameters:
The following factors may be considered in determining whether an uncontrolled transaction is comparable to the controlled transaction for purposes of applying the resale price method as well as to determine whether suitable economic adjustments should be made to account for such differences:
Factors like business experiences (start-up phase or mature phase), management efficiency, cost structures etc that have less effect on price of products than on costs of performing functions should be considered. Such differences could affect Gross Margin even if they don’t affect Arm’s Length Prices of products.
A Resale Price Margin requires particular attention in case the reseller adds substantially to the value of the product (e.g., by assisting considerably in the creation or maintenance of intangible property related to the product (e.g., trademarks or trade names) and goods are further processed into a more complicated product by the reseller before resale).
Level of activities performed and risks borne by reseller. E.g., A buying and selling agent would obviously obtain higher compensation then a pure sales agent.
If the reseller performs a significant commercial activity besides the resale activity itself, or if it employs valuable and unique assets in its activities (e.g., valuable marketing intangibles of the reseller), it may earn a higher Gross Profit Margin.
The comparability analysis should take into account whether the reseller has the exclusive right to resell the goods, because exclusive rights may affect the Resale Price Margin.
The reliability of the analysis will be affected by differences in the value of the products distributed, for example, as a result of a valuable trademark.
In practice, significant difference in operating expenses is often an indication of differences in functions, assets or risks. This may be remedied if operating expense adjustments can be performed on the unadjusted gross profit margins of uncontrolled transactions to account for differences in functions performed and the level of activities performed between the related party distributor and the comparable distribution companies. Since these differences are often reflected in variation of the operating expenses, adjustments with respect to differences in the SG & A expenses to sales ratio as a result of differences in functions and level of activities performed may be required.
The differences in inventory levels and valuation method will also affect the Gross Profit Margin.
Further, adjustment on account of differences in working capital could also be considered (i.e., credit period for payables and receivables, the cycle of inventory, etc).
For RPM, product differences would be less relevant, since one would expect a similar level of compensation for performing similar functions across different activities for broadly similar products. Hence, typically RPM is more applied on the basis of functional comparability rather than product comparability. However, the distributors engaged in sale of markedly different products should not be compared.
Further, differences in accounting practices may be on account of:
Sales and purchases have been accounted inclusive or exclusive of taxes;
Methods of pricing of goods namely, FOB or CIF;
Fluctuations in foreign exchange, etc.
In actual practice, the resale may also be out of opening stock. Similarly, the goods purchased during the said year may remain in closing stock. The process of determination under RPM culminates in cost of sales rather than value of purchases. This cost of sales should be converted into cost of purchases. For this, closing stock of goods purchased from AE should be added and opening stock of purchases from AE should be deducted.
2.8 Judicial Precedents on RPM:
The applicability of the said method on a particular transaction is subject matter of litigation. Some of the decisions are discussed in brief hereunder.
DCIT vs. M/s Tupperware India Pvt. Ltd. [ITA No. 2140/Del/2011 & ITA No 1323/Del/2012]
The tax payer operates as a distributor of plastic food storage and serving containers. It has subcontracted the manufacturing activity to contract manufacturers.
The moulds required to manufacture the product are leased in by the tax payer from the AE’s and thereafter supplied to contract manufacturers. The moulds are owned and developed by the overseas group entities.
The tax payer contended that it did not add any value to the products and carries out the functions of a pure reseller. Further, the tax payer contended that it merely procures the moulds from the AE’s and supplies them to the contract manufacturers. Thereafter, it procures finished goods from contract manufacturers and sells them in Indian market without adding any value thereon. Further, there is strong correlation and interdependence between the purchase of mould and core activity of distributor. Accordingly, RPM is most appropriate method.
The Transfer Pricing Officer (TPO) rejected the same and computed the Arm’s Length Price by applying Transactional Net Margin Method (TNMM).
The Commissioner of Income Tax (Appeals) [CIT(A)] deleted the said addition and the Income Tax Appellate
Tribunal (ITAT) upheld the decision of CIT(A).
ITAT held as follows:
It is clear that there was hardly any value addition made by the tax payer relating to the transaction.
The function of the tax payer was that of the reseller and hence RPM is the most appropriate method in this case.
The TPO without any analysis concluded that
TNMM is the most appropriate method is not based on any facts relevant to the case.
Mattel Toys (I) Pvt Ltd vs. DCIT
The tax payer is a wholly owned subsidiary of Mattel Inc., USA. During the year under consideration, the tax payer imported finished goods and sold them in India as well as exported to AE’s. The tax payer also imported raw material from AE for manufacturing the toys in India.
The tax payer had benchmarked the said transaction using TNMM and in their study report had rejected
RPM method.
The TPO segregated the activities into 3 segments – (i) import of goods from AE and sale in domestic market; (ii) import of goods from AE and sold to AE; and (iii) import of goods from AE and export to third parties outside India.
The TPO worked out operating margin for all the three segments separately and proposed an adjustment. The assessee had contended before TPO for adoption of RPM as most appropriate method. However, TPO rejected the contention of the tax payer.
CIT(A) upheld the view of TPO and confirmed the addition.
The tax payer before ITAT contended that for determination of Arm’s Length Price for distribution activity, RPM is most appropriate. Further, the tax payer contended that its gross profit margin was higher than that of comparables.
ITAT held as follows:-
The nature of product was not much relevant but the functions performed of the comparability are to be seen. It observed, “the main reason is that the product differentiation does not materially effect the Gross Profit Margin as it represents gross compensation after the cost of sales for specific functions performed. The functional attribute is more important while undertaking the comparability analysis under this method. Thus, in our opinion, under the RPM, products similarity is not a vital aspect for carrying out comparability analysis but operational comparability is to be seen.”
It further held that gross profit margin earned by an independent enterprise was a guiding factor in
RPM.
Accordingly, RPM is the most appropriate method for determining Arm’s Length Price for distribution activity. Since the tax payer had adopted TNMM, the matter is remitted back to TPO for de novo adjudication. ITAT directed TPO to determine the Arm’s Length Price based on fresh comparables after considering RPM as the most appropriate method.
ITO vs. L’Oreal India Pvt. Ltd. [ITA No, 5423/ Mum/2009]
The tax payer, a wholly owned subsidiary of L’Oreal SA
France, is engaged in business of manufacturing and distribution of cosmetic and beauty products.
The tax payer operates in two business segments (i) manufacturing and (ii) distribution.
It had incurred huge losses on account of selling and distribution activities incurred as a part of marketing strategy.
In case of distribution segment, the tax payer adopted RPM as the most appropriate method. However, TPO rejected the taxpayer contention and concluded TNMM to be the most appropriate method.
CIT(A) deleted the entire addition on the income of the tax payer.
ITAT held as follows:-
OECD states that in case of distribution and marketing activities, where the tax payer purchases from AE and sales to unrelated parties without adding much value, RPM is the most appropriate method.
In the instant case there is no dispute that the tax payer buys the products from its AEs and sells to unrelated parties without any further processing.
RPM has been accepted in preceding as well as succeeding years in respect of distribution segment of the taxpayer.
Hence, RPM is appropriate method.
Panasonic Sales & Services (I) Company Limited vs. ACIT [ITA No 1957/Mds/2012]
The tax payer is a subsidiary of Panasonic Holdings
(Netherland BV) which is ultimately held by Matsushita
Electronic Co. Ltd., Japan.
The tax payer is engaged in the import of consumer electronic products from its AE for sale in domestic market and also provides market support services.
In case of purchase and resale activity, the tax payer adopted RPM method and for providing market support services, it adopted TNMM method. There was no issue in the value of international transaction and the method adopted by the tax payer to determine the arm’s length price. However, the dispute was as regards the determination of selling price and the calculation of gross profit margin.
The TPO reduced the cash discount offered by the taxpayer for early realisation of dues on account of sales while calculating the gross profit margin. Further, the TPO added the freight and storage charges treating them as direct expenses in relation to purchase of goods.
However, the tax payer contended that TPO erred in considering cash discount with trade discount. Further, the freight and storage expenses incurred are towards outward sales and not inward. The rules clearly states that only expenses incurred in connection with the purchases are required to be reduced from sales.
ITAT held as follows:-
Cash discounts offered to the customers are in nature of financial charges. Further, it is only an incentive
offered for early realisation. Thus held that TPO erred in equating cash discount with trade discount and that the cash discount in the present case was offered after completion of sales which is entirely different in nature from trade discounts.
Further, in case of freight and storage expenses incurred the same were incurred towards the cost of packing and transportation of goods from the warehouse to the customers and hence in the nature of selling and distribution expenses. Thus, it cannot be reduced from the selling price to determine the cost of goods sold.
Danisco (India) Pvt. Ltd. vs. ACIT
The tax payer is engaged in the business of manufacturing food flavours and trading of food additives/ingredients. For manufacturing, the tax payer purchases raw material from its AE. It also imports ingredients from its AE and resells them to its customers in India through distribution chain.
During the year under consideration, the tax payer selected TNMM as the appropriate method to benchmark its transaction. Further, it also carried out supplementary analysis in case of import of goods using RPM as the most appropriate method.
However, TPO rejected the 4 companies selected by the tax payer as comparables on the ground that these companies had negative net worth or persistent loses. Accordingly TPO made an adjustment.
On filing of objections, Dispute Resolution Panel (DRP) upheld the addition made by the TPO. The tax payer went into appal before ITAT.
The tax payer contended that TPO erred in making
the addition on the entire transaction and failed to appreciate the fact that the tax payer had also undertaken transactions with third party. Further, the companies only in manufacturing activity and not in trading activity cannot be considered as comparables. Lastly, TPO should have used segmental accounts furnished by the tax payer to examine the trading and manufacturing activity separately and should have used RPM for trading activity as it is widely used method.
Additionally, assessee relied on OECD guidelines and contended that it merely imported and resold goods without adding any value. Hence, RPM should be applied.
ITAT accepted the contention of the tax payer and restored the matter to the file of TPO for fresh adjudication. It gave the direction to TPO to apply RPM as a most appropriate method for trading transactions of imported goods.
2.9 Berry Ratio – An alternate method of benchmarking for distributor arrangements:
In relation to the distribution arrangements, in addition to the application of RPM as a benchmarking method, International transfer pricing principles have evolved over time. In 2010, OECD updated its transfer pricing guidelines and analysed use of Berry Ratio as a financial indicator for examining the Arm’s Length Price.
The Berry Ratio compares the ratio of gross profit to operating expenses of the tested party with the ratios of gross profit (less unrelated other income) to operating costs (excluding interest and depreciation) of third party comparable companies.
The underlying assumption of the Berry Ratio is that there is a positive relationship between the level of operating expenses and the gross profit. The more operating expenses that a distributor incurs, the higher the level of gross profit that should be derived.
Generally, Berry ratio should only be used to test the profits of limited risks distributors and service providers that do not own or use any intangible assets.
The challenges in using Berry Ratio could be identifying functionally similar comparable entities; comparables used should not own or use significant intangible assets, classification of costs by the comparable entities etc.
However, Berry Ratio could be extremely useful where operating margins are used as a measure of profitability in distribution business with exponential growth patterns.
Having discussed the RPM at length, we will elaborate CPM in the forthcoming paragraphs.
Cost Plus Method – Meaning:
3.1 The Provision of Income Tax Act:
Section 92C of the Act prescribes the method for computation of Arm’s Length Price, wherein Cost Plus Method (CPM) is enlisted as one of the methods. The same is not defined in the Act itself, but has been discussed at length in the Income Tax Rules.
Rule 10B prescribes the manner in which CPM can be applied. The text reads as follows:
“Determination of Arm’s Length Price u/s. 92C.
10B. (1) For the purposes of s/s. (2) of section 92C, the Arm’s Length Price in relation to an international transaction or a specified domestic transaction shall be determined by any of the following methods, being the most appropriate method, in the following manner, namely :—
…
…
cost plus method, by which,—
the direct and indirect costs of production incurred by the enterprise in respect of property transferred or services provided to an associated enterprise, are determined;
the amount of a normal gross profit mark-up to such costs (computed according to the same accounting norms) arising from the transfer or provision of the same or similar property or services by the enterprise, or by an unrelated enterprise, in a comparable uncontrolled transaction, or a number of such transactions, is determined;
the normal gross profit mark-up referred to in sub-clause (ii) is adjusted to take into account the functional and other differences, if any, between the international transaction or the specified domestic transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect such profit mark-up in the open market;
the costs referred to in sub-clause (i) are increased by the adjusted profit mark-up arrived at under sub-clause (iii);
the sum so arrived at is taken to be an Arm’s Length Price in relation to the supply of the property or provision of services by the enterprise;”
3.2 OECD Transfer Pricing Guidelines for Multinational
Enterprises and Tax Administrators:
Cost Plus Method is discussed in the OECD Transfer Pricing guidelines2. It states that the CPM method begins with the costs incurred by the supplier of property/services in a controlled transaction for property transferred or services provided to an associated enterprise. An appropriate mark up is then added to the said cost, in view of the functions performed and the market conditions. Such price is known as the arm’s length price.
Thereafter, the guidelines go on to define the most appropriate situation where CPM may be used, i.e., if one of the following two conditions get satisfied:
none of the differences between the transactions being compared, or between the enterprises undertaking those transactions, materially affect the cost plus mark up in the open market; or
reasonably accurate adjustments can be made to eliminate the material effects of such differences.
The guidelines also stress that in principle, cost plus methodology should compare margins at gross profit level, however there may be practical difficulties in doing so. Thus, the computation of margins should be flexible to such extent.
The OECD guidelines discuss, at length, the applicability of CPM to various situations, determination of appropriate cost base and various adjustments and practical difficulties that may arise for the application of this method.
3.3 UN Practical Manual on Transfer Pricing for Developing Countries:
The UN Practical Manual also discusses Cost Plus Method as a traditional transaction method, and goes on to define the same as per the OECD guidelines.
It further defines the mechanism of CPM, by prescribing the following formula:
TP = COGS x (1 + cost plus mark-up)
Where,
TP = the Transfer Price of a product sold between a manufacturing company and a related company;
COGS = the Cost of Goods Sold to the manufacturing company; and
Cost plus mark-up = gross profit mark-up defined as the ratio of gross profit to cost of goods sold. Gross profit is defined as sales minus cost of goods sold.
From the above, it can be seen that UN Manual also prescribes the practical application of Cost Plus Method, and breaks down the process in formulae and practical steps.
3.4 Most suitable situations for applicability of CPM:
The applicability of a method varies from one case to the other. However, there are certain standard cases where CPM would, most likely, be the most suitable option. The said cases are discussed hereunder:
Sale of semi-finished goods:
The application of CPM to the sale of semi-finished goods has been recommended by the OECD guidelines. However, in order to benchmark the transaction, a functional analysis of the same has to be conducted. Semi-finished goods are of various types, such as complete assembly of goods before sale, or a semi knocked down (SKD) condition. It has to be ascertained that how independent parties would arrive at a mark up, and determine their prices in such cases.
Hence, an appropriate cost base as well as mark up is essential to be derived at in order to benchmark the transactions, and arrive at the arm’s length price. The purpose of benchmarking is to ensure that prices set should give the same price to the associated enterprise as they would if the sales were made to independent parties. In such cases, internal comparable, i.e. sales made by the same manufacturer to associated enterprises as well as third parties, would be the ideal scenario.
However, if the manufacturer is not making similar sales to third parties, external comparables can also be used. For example, say, a manufacturer produces wheat products in a semi finished state, out of the raw material, and then sells the same to its AEs as well as non-AEs at a cost plus mark up of 15%. In this case, it is easy for the manufacturer to determine the cost of the raw materials and the mark up for the functions carried out. In this case, internal comparables are also available, and hence, the benchmarking process becomes considerably simpler.
Joint facility agreements, or Long-term buy & supply arrangements:
The OECD guidelines recommend Cost Plus Method for agreements or arrangements where the manufacturer acts as a contractual manufacturer. A contractual manufacturer is typically one who carries low risk and carries out low-level functions, whereas an entrepreneurial manufacturer is the one who carries majority of the risk and has entrepreneurial and more complex functions. In these cases, functional analysis of the entity is important to determine the category of manufacturer. Mere claim of the entity is not sufficient, and the agreements as well as functions of the entity have to be verified.
After it is determined whether an entity is a contractual or entrepreneurial entity, the comparables can be selected accordingly. This is due to the fact that a contractual manufacturer, bearing low risks, would likely have a less mark up than an entrepreneurial manufacturer, who essentially bears majority of the risks involved.
For example, say, A is a contractual manufacturer, which produces spare parts of computer hardware for its AE, as per the instructions and technical know-how of the AE. In this case, the functionality of ‘A’ is easy to determine, as it is a simpler entity, and thus the costs can be most appropriately determined. Due to less complexity of functions, the mark up to the cost can also be computed as per the agreements with the AE as well as the functions performed by ‘A’. In such a case, CPM is the most appropriate method.
Provision of services:
This is the third broad category which has been recommended by OECD guidelines for the use of CPM. In this category, CPM can be used wherein the services provided by the entity are low-end services. This is due to the fact that high end service providers do not charge fees on a cost plus basis. The true value in such cases is of the service provided, and not of the cost incurred for the provision of the same. For instance, a Chartered Accountant does not charge his fees based on the costs incurred for a study report, but for his expertise and service provided. In such cases, CPM is not the most appropriate method.
However, in low end services, such as in the case of job workers, the worth of the intangibles for value addition does not form a major part of the price, and hence, an appropriate mark up to cost can be easily determined. Hence, CPM is an appropriate method to derive the Arm’s Length Price.
In order to come to the decision whether CPM can be applied to a particular transaction/entity, the actual risk allocation has to be verified. The OECD guidelines3 provide an example, wherein the actual risk allocation is used to determine whether CPM can be used or not. The example reads as follows:
“Company A of an MNE group agrees with company B of the same MNE group to carry out contract research for company B. All risks of a failure of the research are born by company B. This company also owns all the intangibles developed through the research and therefore has also the profit chances resulting from the research. This is a typical setup for applying a cost plus method. All costs for the research, which the associated parties have agreed upon, have to be compensated. The additional cost plus may reflect how innovative and complex the research carried out is.”
Broadly, the CPM is most suitable to the aforesaid situations, but the applicability of the same varies on the facts of each case.
3.5 Situations wherein Cost Plus Method is NOT appropriate:
Furthermore, the UN Practical Manual4 has specified certain transactions wherein the application of CPM is not suitable. It states that where the transactions involve a full-fledged manufacturer which owns valuable product intangibles (i.e., an entrepreneurial manufacturer), independent comparables would be difficult to obtain. Hence, it will be difficult to establish a mark up that is required to remunerate the full-fledged manufacturer for owning the product intangibles. In such structures, typically the sales companies (i.e., commisionaries) will normally be the least complex entities involved in the controlled transactions and will therefore be the tested party in the analysis. The Resale Price Method is typically more easily applied in such cases.
3.6 Steps in application of CPM:
The steps for application of Cost Plus Method, as per
Rule 10B of the Indian Income Tax Act, are as follows:
Ascertain the direct and indirect cost of production.
Ascertain a normal gross profit mark-up to such costs.
Adjust the normal gross profit mark-up referred to in
(2) above to take in to account the functional and other differences.
The costs referred to in (1) above are increased by the adjusted gross profit mark-up referred to in (3) above.
The sum so arrived at is taken to be an arm’s length price.
The application of the aforesaid steps is being shown in the following example:
Production Costs of AE-India = 50
20% = Gross Profit Margin on production costs earned by 3P-India on sales made by other Indian comparable companies
3.7 Advantages and Challenges of CPM:
Advantages of CPM:
The applicability of CPM is based on internal costs, for which the information is readily available with the entity
Reliance is on functional similarities
Fewer adjustments are required on account of product differences than CUP
Less vitiated by indirect expenses which are not “controllable”
Challenges of CPM:
Practical difficulties in ascertaining cost base in controlled and uncontrolled transactions
Difficulties in determining the gross profit of the comparable companies on the same basis, because of, say, different accounting treatments for certain items
Difficult to make adjustments for factors which affect the cost base of the entity/transaction
No incentive for an entity to control costs since the method is based only on actual costs
The level of costs might be disproportionately lower as compared to the market price, e.g., when lower costs of research leads to the production of a high value intangible in the market
3.8 Peculiar Issues in Application of CPM:
The OECD guidelines examine various practical difficulties in the application of CPM, which are being discussed in brief, hereunder:
Determination of costs and mark up:
While, an enterprise would mostly cover its costs over a period of time, it is plausible that those costs might not be determinant of the appropriate profit for a particular transaction of the specific year. For instance, some companies might need to reduce their prices due to competitive pricing, or there might be instances wherein the cost incurred on R&D is quite low in comparison to the market value of the product.
Further, it is important to apply an apt comparable mark up. For example, if the supplier has employed leased assets to carry out its business activities, its cost cannot be compared to the supplier using its own business assets. In such a case, an appropriate margin is required to be derived. For this purpose, the differences in the level and types of expenses, in light of the functions performed and risks assumed, must be compared. Such comparison may indicate the following:
Expenses may reflect a functional difference which has not been taken into account in applying the method, for which an adjustment to the cost plus mark-up may be required.
Expenses may reflect additional functions distinct from the activities tested by the method, for which separate compensation may need to be determined.
Sometimes, differences in expenses are merely due to efficiencies or inefficiencies of the enterprises, for which no adjustment may be appropriate.
Accounting consistency:
Where accounting practices are different in controlled and uncontrolled transactions, appropriate adjustments need to be made in order to ensure consistency in the use of same types of costs. Entities might also differ in the treatment of costs which affect the gross mark-up, which need to be accounted for.
3.9 Critical Points while Determining the Cost Base:
In CPM, it is most important to ensure that all the relevant costs have been included in the cost base in order to determine the Arm’s Length Price. The basic principle is to determine what price would have been charged, had the parties not been connected/associated. The OECD guidelines have discussed the same in depth.
An independent entity would ensure that all costs are covered and that a profit is earned on a transaction with a third party. The usual starting point in determining the cost base would be the accounting practices. The AE might consider a certain kind of expense as operating, while the third party may not do so. In such cases, appropriate adjustments need to be made so as to ensure accounting consistency.
Further, in principal, historical costs should be attributed to individual units of production. However, some costs, such as the cost of materials, would vary over a period of time, and it would be appropriate to average the costs over the period in question. Averaging might also be appropriate across product groups or over a particular line of production, and also for fixed costs where the different products are produced simultaneously and the volume of activity fluctuates.
Another difficulty arises on the allocation of costs between suppliers and purchasers. It may be so that the purchaser bears certain costs so as to diminish the supplier’s cost base, on which mark-up would be computed. In practical situations, this may be solved by not allocating costs which are being shifted to the purchaser in the above manner. For instance, say ‘S’ is the manufacturer of semi-finished goods, and supplies to its AE, viz. ‘P’. For this purpose, ‘S’ purchases raw material from a third party. Ideally, the cost of idle raw material should be borne by the supplier, i.e., ‘S’. However, there might be mutual agreements, wherein the purchaser, i.e., ‘P’, bears such cost of idle raw material, and hence, the cost burden of ‘S’ goes down. In such cases, while deriving at the cost base, appropriate adjustments should be made.
Thus, it is evident that no straight jacket formula can be derived for dealing with all cases. It has to be ensured that there is consistency in the determination of costs, between the controlled and uncontrolled transactions, so as to ensure that the appropriate Arm’s Length Price is obtained.
3.10 Cost Plus Model vs. Cost Plus Method:
Due to the ambiguity in the difference between Cost Plus Method and Cost Plus Model, the same is being discussed hereunder:
Cost Plus Model
It is a pricing model
Mark-up is added on operating costs/total cost
Method adopted in fact is TNMM
Comparison of Net Margins
Cost Plus Method
Method of determining arm’s length price
Mark-up is added on cost of goods sold
Comparison of Gross Margins
3.11 Judicial Precedents on CPM:
The applicability, benchmarking and cost base of CPM has been debated in the courts of law, both Indian and International, time and again. Some of the major judicial precedents are discussed in brief hereunder:
Wrigley India Private Limited vs. Addl. CIT [(2011) 142 TTJ (Del) 23]:
The taxpayer is a subsidiary of a US based company, engaged in the business of manufacture and sale of chewing gums.
The import of raw materials by the taxpayer from its AE constituted 14% of the total raw material consumed.
The taxpayer was selling products in domestic as well as international market.
In case of export to AEs, it benchmarked its transactions using TNMM.
The TPO applied CPM, and held that since the goods exported were same as the ones sold in domestic market to unrelated parties, the domestic transactions could be used as ‘comparable’ to the international transactions.
The ITAT upheld the additions made by using CPM, and observed that the goods sold to AE as well as non-AEs, were the same goods manufactured in the same factory using the same raw materials.
The use of internal comparables was also upheld, as the raw material purchased from the AE was only 14% of the total consumption, and hence, internal CPM could be used by taking GP/direct cost of production as PLI.
ITAT also held that though there was difference in domestic and export market, it should have had a positive impact on margins of the taxpayer as per capita income was higher in foreign countries than India and
the goods sold by the taxpayer were not ‘necessities of life’, but were consumed by middle and higher class people in the society.
Thus, internal CPM was considered to be the most appropriate method.
Diamond Dye Chem Ltd. vs. DCIT [2010-TII-20-ITAT-MUM-TP]:
The taxpayer is engaged in the business of manufacturing Optical Brightening Agents (OBAs), and exported its products both to AEs and non-AEs.
The sales made to AEs were more than 6 times of the sales made to non-AEs. The company adopted TNMM as the most appropriate method to benchmark the transaction.
TPO rejected the said method, and adopted CPM as the most appropriate method, and made an addition of Rs. 3,07,89,380/-.
The taxpayer preferred an appeal before the CIT(A) wherein it submitted that that there were a lot of functional differences between the sales made to AEs and those to unrelated parties, and hence, gross profit mark-up cannot be applied. Without prejudice to the same, the taxpayer also claimed that adjustments for differences on account of volume discounts, and staff & travelling cost of marketing and technical persons must be made while computing the Arm’s Length Price.
The CIT(A) did not accept the contention of the taxpayer for application of TNMM as the most appropriate method. The CIT(A) confirmed the application of CPM by the TPO, but allowed the adjustment on account of “staff and travelling cost of dedicated marketing personnel”. Thus, the CIT(A) arrived at an ALP of 55.27%, and after allowing the benefit of +/- 5% range, confirmed the addition to the extent of Rs. 38,67,421/-.
The ITAT upheld the use of CPM, and held that the taxpayer did not explain substantial differences in functional and risk profile to reject CPM. The ITAT held that the taxpayer could not satisfactorily explain as to what are the substantial differences in the functional and risk profiles of the activities undertaken by the taxpayer in respect of exports made to the AEs and non-AEs.
The ITAT further held that since the cost data for the manufacture of products are available as per cost audit report, the report thereof is assured, and hence, CPM is the most appropriate method.
However, it allowed discount adjustment on account of differences in volumes of sales since the sales made to AEs are almost 6 times to the sales made to non-AEs.
ACIT vs. L’Oreal India Pvt. Ltd. [ITA No. 6745/M/2008]:
The taxpayer is engaged in the business of manufacturing and distribution of cosmetic and beauty products, and is a 100% subsidiary of L’Oreal SA France.
During the AY 2002-03, the taxpayer had purchased raw materials from its associated enterprise and had used CPM to benchmark the same.
The Transfer Pricing Officer (TPO) rejected the same, and computed the Arm’s Length Price by applying Transactional Net Margin Method (TNMM).
The CIT(A) deleted the said addition, and the ITAT upheld the decision of the CIT(A).
ITAT held as follows:
CPM adopted by the taxpayer is based on the functions performed and not on the basis of types of product manufactured, as normally the pricing methods get precedence over profit methods.
Even according to the OECD guidelines, the preferred method is that which requires computation of ALP directly based on gross margin, over other methods which require computation of ALP in an indirect method, because comparing gross margins extinguishes the need for making adjustments in relation to differences in operating expenses, which could be different from enterprise to enterprise.
CPM had been accepted by the TPO in subsequent assessment years.
The Department went in appeal against the aforesaid order before the High Court, wherein the decision of the ITAT was upheld by the High Court.
ACIT vs. MSS India (P.) Ltd. [(2009) 32 SOT 132 (Pune)]:
The taxpayer is a 100% EOU, engaged in the business of manufacturing of strap connectors. It made sales to both its AEs and non-AEs.
83% of the total sales were made to the AEs.
It incurred a loss of 2.35% at the net level.
In order to justify arm’s length price, the taxpayer used CPM as well as TNMM. In TNMM, the taxpayer compared its net loss to the other companies which were incurring more losses. While, in using CPM, the taxpayer used internal comparables, i.e., it compared the margins from AEs and non-AEs.
TPO rejected the use of CPM on the basis that the division of cost was not verifiable. The comparables selected by the taxpayer were also rejected by the
TPO, and fresh comparables were selected.
TPO applied TNMM to benchmark the transactions and make adjustments to the value of sales to derive at an arm’s length price.
The CIT(A) and ITAT both upheld the use of CPM.
The ITAT held as follows:
The TPO rejected the use of CPM stating that “while distributing various costs, it is always difficult to exactly find out the correct ratio in which all these costs should be allocated and if the distribution of all these costs is not done correctly, it may give undesirable results”. The ITAT held that a method cannot be rejected merely because of its complexity.
The relevant considerations for selection of appropriate method ought to be the nature and class of international transaction, the class of AEs, FAR analysis and availability, coverage and reliability of data, the degree of comparability between related and unrelated transactions and ability to make reliable and accurate adjustment in case of differences.
It was not necessary that AEs should enter into international transaction in such a manner that a reasonable profit margin would be earned by the AE, but what was necessary that price charged for such transactions had to be at arm’s length.
ACIT vs. Tara Ultimo (P.) Ltd. [(2012) 143 TTJ (Mum) 91]:
The taxpayer, engaged in manufacture and trade of jewellery, sold finished goods to its AE and adopted CPM to compute ALP of the transaction, using Sales/ GP as the PLI.
TPO rejected the ALP computation made by the taxpayer, and made an adjustment to the taxpayer’s income, using TNMM.
On appeal, the CIT(A) deleted the addition made, and the Revenue went into appeal before the ITAT.
The ITAT made the following observations:
CIT(A) examined only one aspect of the matter i.e. sales of finished goods to the AEs, but failed to examine other aspects of import of diamonds from
AE and export of diamonds to AEs. Hence, the ITAT held that the CIT(A) had erred in rejecting TNMM.
The taxpayer had not placed on record any evidence to support ALP of diamonds imported and exported or to justify that the transactions were made at prevailing market price.
In the absence of documentation to support use of direct method such as CUP, CPM or Resale Price method, it was imperative to use indirect methods of determination of ALP i.e., TNMM or profit Split method.
The taxpayer had made comparison on ‘global level’ instead on ‘transaction level’. Further, one of the important input i.e., diamond had been imported from AEs where the arm’s length nature of the transaction was not established.
In view of the above, ITAT rejected the CPM method, and remanded the matter back to the CIT(A) for fresh determination.
Conclusion:
Various guidelines have been developed to assist the countries in proper tax administration, as well as MNEs to reasonably attribute the appropriate profit to each jurisdiction. In a global economy, where MNEs play a prominent role, transfer pricing is a major issue for tax administrations as well as taxpayers. In order to ensure that the respective governments receive the revenue that they are entitled to, and that the MNEs pay proper tax without suffering the consequence of double taxation, various methods and guidelines have been developed.
Resale Price Method and Cost Plus Method, have been discussed at length herein. However, it is pertinent to mention that the facts of each case may be unique, and need to be scrutinised independently before coming to a conclusion for the applicability of the most appropriate method. The purpose of the method is merely to arrive at the arm’s length price, for which several adjustments may need to be applied. It is important to use the above method with suitable flexibility for the same. It is advisable to reject the other methods before accepting most appropriate method for computation of arm’s length price. In conclusion, it is the intent and the essence of the provisions and the method to be kept in mind, and not merely the procedure.
Further, recently OECD has launched an Action Plan on Base Erosion and Profit Shifting (BEPS) identifying 15 specific actions needed in order to equip governments with the domestic and international instruments to address the challenge of MNEs adopting aggressive tax planning and profit shifting. The objective of this plan is to prevent double non-taxation and proper allocation of profits between various jurisdictions. The said objective can be achieved by appropriate FAR analysis and by selecting the most appropriate method for benchmarking the transaction between two associated enterprises.
