Thursday, June 18, 2009

Transactional Net Margin Method: Turbo TaxGuru

It is a great opportunity to explain my experiences in Transfer Pricing concepts and methods to substantiate the tax payer’s Arm’s length price or standards.

Today, I would like to explain about the Transactional Net Margin Method in a more practical manner.

Under the TNMM ( Transactional Net Margin Method), it compares the normal Net profit margin on sales or on costs or assets employed or having regard to any other relevant base, realized by the associated enterprises, to the Net profit margin realized by unrelated enterprises from comparable uncontrolled transactions. Actually, TNMM has to be selected as a last resort, but practically, every person / consultant is using this method as a priority method globally.

First, we have to select a profit level indicator (PLI) , which is a reliable measure of an arm’s length result. Based on functional analysis, net profit to total cost or net profit to sales or operating profit to sales or operating profit to operating cost ( or total cost) is to be selected as an appropriate PLI.

Search for comparable companies

In India, there two financial data bases basically using by the Indian Revenue Authorities as well as the Tax Consultants. They are : Prowess by CMIE ( Centre for Monitoring of Indian Economy Ltd) and Capitaline-2000 by Capitaline Markets India Pvt. Ltd. Each data base consists of 12,000 to 15,000 Corporates’ financial information of listed companies and some are unlisted also. The data is collected from annual/quarterly results, government reports and other sources. The objective of our search from those data bases for comparable companies was to identify a group of independent companies which are broadly functionally similar and operate in broadly similar markets to that of the tax payer’s company’s business profile.

Search Process:

Based on ‘Economic activity’ , ‘classifications’ or Products/services etc, we have to generate companies initially. For ex: if the tax payer’s company is a routine contract Software Development Service provider, the following services can be taken into account:

• Computer software
• Computer software and services
• Software services and consultancy
• Software products
• Software Development Services
• Software services
• Computer Software and consultancy
• Software Product Development
• Computer software – large
• Computer software – small/medium
• Computer Software – converts

Then, initial set of some ( say 600 ) comparable companies have been generated from the data bases: ( Note: from each data base, you have to generate companies separately)

Then, all the elimination search criteria from those comparable companies is as follows:

Analysis for Financial year 2008-09:
Elimination process: (quantitative screening)

• Companies having no financial data as on March, 2009
• Companies having no sales as on March, 2009
• Companies having sales less than Rs.1 Crore
• Companies having the ratio of Manufacturing sales/Total sales > 25%
• Companies having the ratio of trading sales / total sales > 25%
• Companies having the ratio of R & D / total sales > 5%
• Companies having the ratio of Marketing / total sales > 5%
• Companies having no segmental data
• Companies having employee cost to sales < style="font-weight: bold; color: rgb(153, 0, 0);">Qualitative screening ( elimination process):

The next step is to review the company’s Director’s report, Management Discussion and Analysis report, Background information, product/service profile, Notes to the accounts, etc. After study of these reports from the public data bases:
• Eliminate companies that were not functionally comparable to the tax payer’s company ;
• Eliminate companies having controlled transactions i.e. related party transactions > 25%
• Eliminate companies engaged in software products or different products.
• Undertook a qualitative review of the companies having segmental data.

After this process, details of the companies eliminated in the qualitative screening are to be given:

At the conclusion of our search, we were left with some ( say 10 ) broadly comparable independent companies. ( final set of comparables).

For these final set of comparable companies, we have to arrive arithmetic mean ( average) of Operating profit / sales X 100 or Operating profit / total cost x 100 i.e. operating profit margin on sales or operating profit margin on cost has to be arrived at, while comparing the operating profit margin on sales or on cost of the tested party i.e. tax payer’s margin.

For example: The net margin on cost of the tested party comes to 15% as against the arithmetic mean ( average) of the net margin on cost of the comparable companies comes to 12%, then it means, that the pricing of the tax payer’s company is within the Arm’s Length Standard.
The Author is a well experienced Transfer Pricing Specialist from India, from Turbo TaxGuru Services. The website is :

Please utilize the transfer pricing services from Turbo TaxGuru Services for fixing the Arm’s Length price.

Please wait and watch for my next blog on ……. Multiple year data and calculation of Arm’s Length price and Arm’s Length Range.

Please forward this blog to all your friends, interested persons, corporate circles etc. for knowledge and information.

Disclaimer: The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we Endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation or the above material subject.

Wednesday, June 3, 2009

Cross Border Transations - Transfer Pricing

Transfer pricing – keeping issues at arm’s length Standard
Certain significant transfer pricing issues and controversies have emerged from the past assessments and require appropriate resolution.
With about nearly six years of experience on transfer pricing regulations in India, the tax authorities and practitioners have made a lot of effort to move up the learning curve. However, certain significant transfer pricing issues and controversies have emerged from the past assessments and require appropriate resolution through issuance of necessary administrative guidelines and/or introduction of suitable amendments to the Income-Tax Act, 1961 and the Income-Tax Rules, 1962. Further, certain other provisions need to be introduced in the Act/Rules for alignment of our transfer pricing regulations to OECD guidelines and other international best practices.
This article deals with various such issues and provide for specific suggestions/amendments in the Indian transfer pricing regulations so that there is more certainty and fairness in the manner in which the law will be applied.

Comparable data

The US transfer pricing regulations prescribe that if material differences exist between the controlled and uncontrolled transactions, adjustments must be made to the results of the uncontrolled transaction so that the arm’s length range will be derived only from those uncontrolled comparables that have, or through adjustments can be brought to, a similar level of comparability and reliability.
While the Indian transfer pricing regulations provides for making adjustments for differences between the international transactions and uncontrolled transactions, in practice there is no guidance/clarity or rules in I.T.Rules on the manner in which these adjustments are to be made.
For example, adjustments in areas such as differences in levels of working capital, risk adjustments and volumes, pricing on marginal cost, start-up losses/capacity unutilization, etc., are not clearly permitted. Nowhere is mentioned in the Incometax Act or in the Income-tax Rules, the procedure or formualae for adjustment of the above nature of differences between controlled and uncontrolled transactions.
Appropriate guidance on the manner in which adjustments may be made to enhance comparability between uncontrolled and international transactions would go a long way in alleviating taxpayer burden.

Advance Pricing Agreements

APA is an arrangement that determines, in advance of controlled transactions, an appropriate set of criteria for determination of the transfer pricing for those transactions over a fixed period of time.
While the Indian transfer pricing regulations have not included provisions for APA so far, countries such as the US, Canada, France, the UK, Australia and Japan have successfully implemented them.
Since Indian transfer pricing regulations are already six years old and about three years of transfer pricing assessments have been completed, this may be an opportune time for India to consider introducing APA provisions to provide an opportunity to enterprises to draw up a binding taxation agreement in advance with the authorities on the price or profitability for the controlled transactions.

Need for ‘intangibles’

At present, Indian transfer pricing regulations do not have a specific provision dealing with the transfer pricing of intangibles. Sub-section (2) of Section 92 of the Act is an omnibus provision dealing with intra-group arrangements for services, cost allocations, cost contributions, etc.
Also, the five prescribed transfer pricing methods are generally not found adequate to deal with the transfer pricing issues related to intangibles. Accordingly, in line with international practice and OECD principles, guidance should be issued by the CBDT in India, to recognise certain methodologies/approaches for evaluating the arm’s length character of transactions involving intangibles. So far, there is no”Other method” prescribed by the Board.

Non-integral Intra-Group Services

Non-integral services are ones that are not the principal business activity of the entity providing the services. These incidental services could take the form of administrative services, centralised support services, marketing support services, etc. Taxpayers face hardship where tax authorities treat non-integral services as intra-group services requiring cross-charge and attribute a mark-up on the same. For ex: reimbursement of expenses, purchase of fixed assets, etc.
Owing to the lack of clarity, economic double taxation results where the tax authority of the other contracting entity disputes the charge and/or the mark-up.
Suitable guidance should be issued in the I.T.Rules, that can help taxpayers and tax authorities deal with the issue of intra-group services in accordance with economic principles.

Use of multiple year data

Tax authorities have been insisting on benchmarking tested party results with margins of comparable companies using single-year financial data relating to the same fiscal year. Practically, same-year comparable data is not completely available with the taxpayer at the time of entering the international transaction as well as at the time of completing the documentation.
Further, from an economic perspective, the use of multiple-year data is based on robust economic logic, as the results of any one-year may be distorted by differences in economic or market conditions and the features and operations of the enterprise affecting the controlled or uncontrolled dealings.
Moreover, participants in an industry may not be uniformly affected by business and product cycles, and therefore differences between dealings may reflect differences in circumstances, not the effects of non-arm’s length dealings.
Accordingly, for evaluating outcomes from an arm’s length perspective, it is preferable to use multiple-year data for taxpayers as well as comparables. But the TPOs in India are using only single year data at the time of preparing the T.P. order i.e. after two years from the end of the specified financial year and by that time, they get the data from the public data bases i.e. Prowess from CMIE and Capitaline-2000 from Capitaline Market India Ltd, which are used by both the Government and the Chartered Accountants in India, whereas at the time of filing of the return, the tax payers are not getting the full data from those public data bases. These differences have to be adjusted by using single year data with some adjustment or by using multiple year data without adjustments.
But one point, the cost plus mark-up cannot be worked out, basing on the comparables found in the public data bases and their average PLI worked out by the tax payers. The margins should be based on the pure business average profit-margins in the relevant and specified industry.
A standard set of search process and search criteria should be drawn from the use of public data bases by the Board, while analyzing the comparables in different industries in India, so that the tax payers can follow that strictly. But now, each party is following according to their own search process and search criteria without any valid methods and standards and arriving results according to their favour. This is to be stopped by the tax authorities in India.

Use of Secret Comparables

Collection of data by the tax authorities, which is not otherwise available in public domain, is a global concern from a confidentiality perspective. Many developed countries do not permit use of secret data while carrying out transfer pricing assessments.
Whereas in India, in certain cases, information gathered by the tax authorities, while investigating the transfer prices of competitors, is being used against the taxpayer. It would seem justifiable not to use one taxpayer’s data against another taxpayer.
In view of the generally accepted international practice, it is proposed that necessary clarification be issued restricting use of secret comparables, which the taxpayer cannot assess to benchmark its transfer price.

Domestic Correlative Adjustments

Indian transfer pricing regulations, as they currently stand, does not permit correlative adjustments, resulting in economic double taxation. For example, in case an India branch of a foreign bank faces transfer pricing adjustment on account of charging less than arm’s length rate of interest on surplus funds lend to the resident NBFC company of the same group, the NBFC is unable to get a deduction for the higher interest, which has been taxed as income in the hands of the India branch.
This results in economic double taxation. It is important to also note that both the India branch and the NBFC are liable to tax in India, hence the transaction between the two does not affect the Indian tax base.
Considering the hardship faced by the taxpayers, it is suggested that necessary amendments be made in the Act and correlative adjustments should be permitted.
It is time to have a relook at the transfer pricing regulations and settle the issues/controversies through issuance of necessary administrative guidelines and/or introduction of suitable amendments in the Act/Rules. Moreover, introduction of measures such as APAs, guidelines on intangibles, etc., would ultimately lead to growth in the

Indian economy. In respect of use of Public data bases also, a standard search process and search criteria should be adopted / given in the Act/Rules for analyzing the correct comparables in various types of industries.
(The Author is a TaxGuru in Turbo TaxGuru Services Pvt. Ltd., Hyderabad, India and New York, USA).

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