1. CA Hiren D Shah hirenindia@hotmail.com

2. Specific Domestic Transactions

3. Technical Analysis

4. 4 Manage the process Accountant’s Report Benchmarking Gathering Background Information Documentation 1 5 2 3 Functional Analysis 6

5.  Ownership Structure  Profile of the company  Overview of industry  Competition faced by the company

6.  Nature & Terms of transactions  Functional Analysis( FAR) Functions performed Risk Assumed  Product liability Risk  Foreign Exchange Risk  Business Risk  Market Risk Asset Utilized  By Tested Party  By its AE

7.  Selection of Method  Analysis of activities of the Tested Party  Search for Comparable Companies

8.  Profitability Measure  Arm’s Length Range  Profitability Analysis of the Company

10. Tested Party

11.  In order to determine the most appropriate method for determining ALP, it is the first necessary to select the “Tested Party”.  The Transfer pricing legislation in India does not provide any discussion or mention of the concept of “Tested Party”.  Tested Party means a participant in an international transaction with reference to which the international transactions is tested.

12.  The tested party would have a lesser risk as compared to the other transacting party.  The selection of tested party must be borne in mind while applying the CPM, RPM or TNMM.  The selection of the tested party would have an influence on the selection of the most appropriate method to benchmark the international transaction and consequently on the comparables selected.

13.  In case Indian taxpayer is selected as the tested party, then ◦ Companies having functional profile similar to the Indian company and operating in India will have to be selected as comparables.  In case the foreign AE is selected as the tested party, then ◦ Comparables performing similar functions as the AE in the territory in which the AE operates will have to be selected as comparables.

14.  Section 1.482-5 of the US Transfer Pricing regulations state that “The tested party will be the participant in the controlled transactions whose operating profit attributable to the controlled transactions can be verified using the most reliable data and requiring the fewest and most reliable adjustments and for which reliable data regarding uncontrolled comparables can be located.”

15.  Generally, the entity which performs simpler functions and which does not own any valuable non-routine intangibles is selected as the tested party.

16.  Tribunal held that under the Transfer Pricing Mechanism, out of two parties of a multinational involved in the transaction, the least complex party not owning intangible assets is to be taken as a tested party.

17.  The Delhi tribunal upheld that the decision of CIT(A) by accepting fact that the least complex entity should be chosen as the tested party. However, due to lack of availability of adequate data, the tribunal treated the Indian entity as tested party.

18.  The assesse had chosen foreign AEs from whom components were imported as tested parties and had computed profit of AEs with comparable chosen from Indian and other data base. Since all international transactions were claimed at ALP, AO referred the question of determination of ALP to TPO. TPO agreed that TNMM was rightly applied, however, he did not agree that foreign AE could be taken as tested parties while determining ALP of imported electronic components and finished goods.

19.  When applying a cost plus, resale price or TNMM, it is necessary to choose the party to the transaction for which a financial indicator ( mark-up on cost, gross margin, or net profit indicator) is tested. The choice of tested party should be consistent with the functional analysis of the transaction. As a general rule, the tested party is the one to which a transfer pricing method can be applied in the most reliable manner and for which the most reliable comparables can be found i.e. it will most often be the one that has the least complex functional analysis.

20.  It is clear from these decisions that though foreign party can be tested party but due to lack of the availability of required data about foreign party, practically in almost all decisions, Indian party is preferred as tested party.

21. Profit Level Indicator Analysis

22.  Comparative analysis of the functions and risks of the tested party  PLIs can be measured in five different ways Operating margin Return of Assets Net Cost Plus Berry Ratio Gross Margin

23. PLISectors ManufacturerDistributorService Provider Operating margin ___ Return on Assets ___ Net Cost Plus ___ Berry Ratio Gross Margin ___

24.  Operating Margin = Operating Profit Net Revenue  Return on Asset = Operating Profit Operating Asset  Net Cost Plus = Gross Profits COGS  Berry Ratio = Gross Profits Operating Expenses  Gross Margin = Gross Profit Revenue 100

25. Revenue Based Analysis:  Average Mean = Total of OPBIT Total of Revenue Cost Based Analysis :  Average Mean = Total OPBIT Total Operating Cost  This Average Mean should be the Benchmark for the tested party to compare its profitability. v v 100

26. Selection Of Most Appropriate Method

27. Traditional Transaction method:  Comparable Uncontrolled Method (CUP)  Resale Price method (RPM)  Cost Plus Method (CPM) Transactional Profit Method  Profit Split Method (PSM)  Transactional Net Margin Method (TNMM)

28.  Traditional transaction methods are the most reliable means of establishing arm’s length prices or allocations. However, the complexity of modern business situations may make it difficult to apply these methods.  Where the information available on comparable transactions is not detailed enough to allow for adjustments necessary to achieve comparability in the application of a traditional transaction method, taxpayers may have to consider transactional profit methods.

29.  However, the transactional profit methods should not be applied simply because of the difficulties in obtaining or adjusting information on comparable transactions, for purposes of applying the traditional transaction methods.  The same factors that led to the conclusion that it is not possible to apply a traditional transaction method must be considered when evaluating the reliability of a transactional profit method.

30. ManufacturerDistributorService Provider CUP----- RPM----- CPM----- PSM----- TNMM

31. Data Strategy

32.  Use of Data base  Data Search Strategy

33.  To identify a group of independent companies with publicly available data that performed broadly similar functions operate in broadly in similar markets and bear broadly similar risk to that of tested party.  In India two financial database are available to search for comparable companies. 1.Capital line plus 2.Prowess

34.  Using the above databases, one can arrive at a set of comparable which are closest to the tested parties.  The next step is Accept/Reject analysis.

35. Database Industry Database A Database B Database C Core Manufacturing Elimination of companies with insufficient data 40 Companies

36. Accept Reject Analysis

39.  Analysis of annual reports, information available on database / website and other publicly available information on the internet.  Manual Selection Process  Data are comparable but on technical assessment, they are not comparable.

40. The Accept / Reject matrix is prepared in practice to provide the list of all the companies that have passed through the final qualitative filtration process and the manner in which each company was dealt with in this process.

41. 41 Database Industry Database A Core Manufacturing Elimination of companies with insufficient data 1. Segment Analysis 2. Must not engage in significant related party transactions 3. Must not own valuable IPRs 1.Data – Non Availability, 2. Continuous Loss making, 3. Companies not engaged into R&D 4.Sales Filter 5. Government Ownership Quantitative Criteria Qualitative Criteria Database B Database C 40 Companies 25 Companies 15 Companies 8 Acceptable Companies for Comparison

42.  The Accept/Reject matrix is particularly useful while rejecting companies that are facing extreme economic circumstances.  It has been held by the Indian courts that any conclusion reached for a particular company should be based on an analysis of all the relevant factors and not just on the economic outcome of a company.

43.  The reasons for rejecting the companies should be probed in to adequately documented to justify the exclusions of such company. This has been witnessed in the ITAT Ruling in the case of Quark Systems India Pvt. Ltd.( Supra).

44. FAR Analysis

46.  Functions performed are the activities that are carried out by each of the parties to thetransaction.  Important and significant functions are considered.  Some of the important functions that are generally observed and examined in a transaction are: ◦ Research and Development ; ◦ Process engineering and designing work ; ◦ Purchasing and materials management ; ◦ Manufacturing, production or assembly work ; ◦ Warehousing and inventory ; ◦ Marketing and distribution ;

47.  One needs to identify the assets ( tangible as well as intangible) used in the course of international as well as Domestic transaction.  Identification of the type of capital assets used, as well as the capital assets left idle and the nature of assets used, such as the age, market value, location etc.

48.  Assessment of risk is important aspect of the FAR Analysis process  Identification of various risks that are assumed by each of the parties to the transaction.  More risk, More Returns are expected.

49. Different Risk undertaken by the companies

50.  Typical transaction where CUP can be adopted are: ◦ Transfer of goods ◦ Provision of Services ◦ Intangibles ◦ Loans. Provision of finance  Examples : ◦ Royalty payment ◦ Transaction dependent on publicly available market quotation (e.g.: gold whose prices are available at the commodity exchange) etc

51.  RPM can be adopted when transactions are of distribution of Finished products or other goods involving no or Little value addition.  Illustration:   Sells Sells  @ Rs 10 @ Rs 12 Foreign co. Indian Co Indian Co (AE) (Tested Party) (Unrelated Party) Fire US Ltd Fire India Ltd Water India Ltd RPM Applicable? YES

52.  Typical Transaction when CPM can be adopted ◦ Provision of services ◦ Joint facility arrangements ◦ Transfer of semi finished goods ◦ Long term buying & selling arrangements

53.  Typical transactions where PSM can be adopted ◦ transfer of unique intangibles ◦ multiple inter-related international transactions which cannot be evaluated separately.  However PSM is not widely used in practice since it is difficult to apply.

54.  TNMM is generally considered as a method of last resort and is applied when it is not possible to apply any other method to determine ALP.

55. Benchmarking Analysis

56.  Benchmark means to find out the Average mean of companies that are accepted in Accept / Reject matrix.  For e.g. Suppose through Accept / Reject matrix, 8 companies are accepted after passing Qualitative and Quantitative Filtration Process. Calculation of their Average mean is as follows:

57.  Transfer Pricing regulations provides for computation of the notified controlled transactions to be at arm’s length price (ALP).  ALP shall mean that the price charged for a transaction between AE’s shall be the same that would be charged had the transaction been between two unrelated parties.  Six methods have been prescribed by the Act for the determination of ALP. Benchmarking Process  The transaction is then benchmarked against the ALP. The process of finding transaction/data comparable to the controlled transaction to determine the ALP of the transaction is referred to as the “Benchmarking Process”

59. Revenue Based Analysis:  Average Mean = Total of OPBIT Total of Revenue Cost Based Analysis :  Average Mean = Total OPBIT Total Operating Cost  This Average Mean should be the Benchmark for the tested party to compare its profitability. v v 100

60. Arm’s Length Determination

61.  Arm’s Length should be determined by comparing Benchmark vis-à-vis PLI of tested party.  If it falls within the range of 3% +/-, then transactions of Tested Party with its AE are at Arm’s Length.

62. Thank You