The Minister of Finance, Mr. Arun Jaitley’s maiden budget for the year 2014-15 proposed to put rest the fiery debates questioning the tax instability in India. With tax demand of more than INR 4 Lakh Crore under dispute and litigation before various Courts and Appellant authorities, the budget proposed to make amendments to certain tax regulations in order to reduce litigation in the field of taxation, in particular – Transfer Pricing.
A sizeable number of disputes rose solely on the grounds of comparability or benchmarking analysis, some of which were addressed through introduction of necessary reforms in the Indian transfer pricing regulations to bring it in line with the global best practices.
Amongst others, one such reform proposed by the Minister of Finance for the year 2014-15 in Parliament was the introduction of range concept for determination of arm’s length price.
The companies registered in India under the Indian Company Act, are required to benchmark the price at which they enter into an international transaction or specified domestic transaction with their associated enterprises (AEs) by determination of arm’s length price.
Until now, by way of regulation per Indian Income Tax Act, 1961 (the Act), the arm’s length price is computed with reference to the arithmetic mean of comparables, with a tolerance limit amended to +/- 1% for wholesale traders and +/- 3% for others from the earlier bandwidth of +/- 5% computed from the transfer price.
To give an example, assuming the arm’s length price, represented as the mean operating profit/total cost, of the tested party is 10%, a captive service provider would be considered to be at arm’s length, if the arithmetic mean of mark-up earned by the comparables ranges between 6.70% [ i.e. ((100+10)*97%) – 100] and 13.30% [i.e. ((100+10)*103%) – 100].
In such a case, a captive service provider might set its transfer price to operate at a loss and yet it would still continue to adhere to be at arm’s length price per the Indian transfer pricing regulations. Considering that the Revenue authorities would not generally concur to a captive service provider operating at a loss or only earning a mark-up of 10.00%, essentially creates a paradox of law.
This projected a sheer lack of economic and statistical rationale, primarily for the reason that arithmetic mean leads to distorted results due to extreme values (outliers), which are not representative of the whole data and might also indicate abnormal circumstances.
By implication, the sustenance of any one comparable could distort the transfer pricing policy of the taxpayer and lead to fresh tax liability. This risk is amplified by inclusion of super-high profit making companies, selected on a routine basis by the transfer pricing officers (TPOs), as comparables for captive service providers.
Not surprisingly, the ambiguity surrounding the computation of arm’s length price has led to several disputes between the taxpayers and the revenue authorities. The recently pronounced ruling by the Mumbai Special Bench in the case of Maersk Global Centres India Private Limited (ITA No.7466/Mum/2012) held that an entity satisfying the comparability analysis should not be rejected solely on the basis of abnormal high margin. In contrast, the ruling by the Pune Income Tax Appellate Tribunal (ITAT) in the case of Bindview India Private Limited held on the basis of several preceding rulings that if abnormal loss making companies are to be excluded, then abnormally high profit making companies should also be excluded.
These and several other rulings contradicting in nature only fuelled the confusion and uncertainty of stance adopted by the revenue and the appellate authorities in the country.
Due to the dispersion and skewness of the final set of comparables, the application of band around arithmetic mean may represent 0% to 100% of the actual observations. On the other hand, since the inter-quartile range from the 25th percentile to the 75th percentile, the resultant range for determination of arm’s length price would always represent about 50% of the observations (i.e. 25% of observations on either side of the median) of the distribution and would eliminate the outliers consequently increasing the reliability of the results.
It is noteworthy to mention that at least 25 countries, falling in both categories of “developed” and “underdeveloped” economy, either mandate or prefer the concept of inter-quartile range or median namely Australia, China, Denmark, France, Germany, Italy, Korea, Malaysia, Netherlands, Singapore, Spain, South Africa, Thailand, Sweden, UK, USA, New Zealand, Argentina, Colombia, Indonesia, Taiwan, Austria, Belgium, Finland and Romania[1]. Additionally, even the Organization for Economic Co-operation and Development (OECD) recognizes the concept of the interquartile range and its potential validity.
The computation of the arm’s length price consequent to the amendment proposed can be better explained by way of an illustration.
Figure 1: Illustration to compare Arithmetic Mean versus the Range Concept
If the tested party earns a margin of 4.00% with the comparable independent enterprises earning a margin ranging from 3.50% to 12.50%, then the interquartile range would be the 25% to the 75% percentile of the set (i.e. 6.20% – 8.10%), which essentially leads to the question of which data point is the arm’s length price?
To clarify, the arm’s length price can be considered to be any of the data points between 6.20% to 8.10% by application of the interquartile range. However, it is important to note that this full range is only acceptable if the selected comparables are virtually perfect comparables to the tested party and the full range is narrow.
Practically, the selected comparables are seldom perfect comparables and are selected as the closest comparables to the tested party by virtue of availability of data. Since median represents 50% of the observations in the set, it is a reliable indicator of the margins earned by the comparables, considered appropriate to gauge the performance of the industry. In this case, the median of 7.40% can be considered to be the arm’s length price.
Therefore, the tolerable limit requires the median to be in the range of 0.88% [i.e. ((100+4.00)*97%) – 100] and 7.12% [i.e. ((100+4.00)*103%) – 100], for the transfer price at which the margin is earned to be at arm’s length. In this case, since the tested party earns a margin of 4%, and the median is 7.40%, the median falls outside the tolerable limit of 3% (i.e. Maximum 7.12%) from the transfer price and the income earned by the tested party would be adjusted to the median of 7.40% by the revenue authorities. Thereby, the companies can use the median as the arm’s length price to set a transfer pricing policy to be well within the resultant arm’s length range.
At this juncture, the authors would like to highlight that the revenue authorities of several nations including China, Austria and others use Median as the arm’s length price. Few countries even accept the arm’s length price to be lower than the median on fact specific cases.
Going by the historical trend with regards to the Indian scenario, if the comparable sets adopted by the TPOs for the Information Technology enabled Services (ITeS) segment is to be considered, then the resultant statistical figures are displayed in Figure 2.
Figure 2: Interquartile Range of the ITeS Set adopted by the Transfer Pricing Officers
The use of interquartile range does not come without its own shortcomings. A potential problem with using the interquartile range is the discarding of more accurate comparables which fall within the full range but outside the inter-quartile range. This problem arises when some of the companies in the reported list are less reliable comparables than others[2].
Further, the adoption of median as the arm’s length price may itself be contested by the taxpayers especially in the cases of abnormal circumstances which might once again spur prospects of litigation.
It is important to note our Minister of Finance has not altogether dispersed off the concept of the arithmetic mean and stated that, it shall continue to apply where number of comparables is inadequate. The subjective view of adequacy could itself be under question. The consolation however is that the data is still under analysis and appropriate rules shall be prescribed once finalized.
This only provides credence to the fact that transfer pricing is not an exact science and there might be instances where application of interquartile range may also not be feasible. Nonetheless, with the objective of conciliating with the investors, the step to align the regulations per the best available practices is undoubtedly right.
[1] 2012 global transfer pricing tax authority survey
[2] http://www.hmrc.gov.uk/manuals/intmanual
A sizeable number of disputes rose solely on the grounds of comparability or benchmarking analysis, some of which were addressed through introduction of necessary reforms in the Indian transfer pricing regulations to bring it in line with the global best practices.
Amongst others, one such reform proposed by the Minister of Finance for the year 2014-15 in Parliament was the introduction of range concept for determination of arm’s length price.
The companies registered in India under the Indian Company Act, are required to benchmark the price at which they enter into an international transaction or specified domestic transaction with their associated enterprises (AEs) by determination of arm’s length price.
Until now, by way of regulation per Indian Income Tax Act, 1961 (the Act), the arm’s length price is computed with reference to the arithmetic mean of comparables, with a tolerance limit amended to +/- 1% for wholesale traders and +/- 3% for others from the earlier bandwidth of +/- 5% computed from the transfer price.
To give an example, assuming the arm’s length price, represented as the mean operating profit/total cost, of the tested party is 10%, a captive service provider would be considered to be at arm’s length, if the arithmetic mean of mark-up earned by the comparables ranges between 6.70% [ i.e. ((100+10)*97%) – 100] and 13.30% [i.e. ((100+10)*103%) – 100].
In such a case, a captive service provider might set its transfer price to operate at a loss and yet it would still continue to adhere to be at arm’s length price per the Indian transfer pricing regulations. Considering that the Revenue authorities would not generally concur to a captive service provider operating at a loss or only earning a mark-up of 10.00%, essentially creates a paradox of law.
This projected a sheer lack of economic and statistical rationale, primarily for the reason that arithmetic mean leads to distorted results due to extreme values (outliers), which are not representative of the whole data and might also indicate abnormal circumstances.
By implication, the sustenance of any one comparable could distort the transfer pricing policy of the taxpayer and lead to fresh tax liability. This risk is amplified by inclusion of super-high profit making companies, selected on a routine basis by the transfer pricing officers (TPOs), as comparables for captive service providers.
Not surprisingly, the ambiguity surrounding the computation of arm’s length price has led to several disputes between the taxpayers and the revenue authorities. The recently pronounced ruling by the Mumbai Special Bench in the case of Maersk Global Centres India Private Limited (ITA No.7466/Mum/2012) held that an entity satisfying the comparability analysis should not be rejected solely on the basis of abnormal high margin. In contrast, the ruling by the Pune Income Tax Appellate Tribunal (ITAT) in the case of Bindview India Private Limited held on the basis of several preceding rulings that if abnormal loss making companies are to be excluded, then abnormally high profit making companies should also be excluded.
These and several other rulings contradicting in nature only fuelled the confusion and uncertainty of stance adopted by the revenue and the appellate authorities in the country.
Due to the dispersion and skewness of the final set of comparables, the application of band around arithmetic mean may represent 0% to 100% of the actual observations. On the other hand, since the inter-quartile range from the 25th percentile to the 75th percentile, the resultant range for determination of arm’s length price would always represent about 50% of the observations (i.e. 25% of observations on either side of the median) of the distribution and would eliminate the outliers consequently increasing the reliability of the results.
It is noteworthy to mention that at least 25 countries, falling in both categories of “developed” and “underdeveloped” economy, either mandate or prefer the concept of inter-quartile range or median namely Australia, China, Denmark, France, Germany, Italy, Korea, Malaysia, Netherlands, Singapore, Spain, South Africa, Thailand, Sweden, UK, USA, New Zealand, Argentina, Colombia, Indonesia, Taiwan, Austria, Belgium, Finland and Romania[1]. Additionally, even the Organization for Economic Co-operation and Development (OECD) recognizes the concept of the interquartile range and its potential validity.
The computation of the arm’s length price consequent to the amendment proposed can be better explained by way of an illustration.
Figure 1: Illustration to compare Arithmetic Mean versus the Range Concept
| Particulars |
Average Operating Margin Results (%)
|
| Comparable 1 |
12.50
|
| Comparable 2 |
3.50
|
| Comparable 3 |
7.40
|
| Comparable 4 |
8.10
|
| Comparable 5 |
6.20
|
| Maximum |
12.50
|
| Upper Quartile |
8.10
|
| Median |
7.40
|
| Lower Quartile |
6.20
|
| Minimum |
3.50
|
| Arithmetic Mean |
7.54
|
| Tested Party |
4.00
|
To clarify, the arm’s length price can be considered to be any of the data points between 6.20% to 8.10% by application of the interquartile range. However, it is important to note that this full range is only acceptable if the selected comparables are virtually perfect comparables to the tested party and the full range is narrow.
Practically, the selected comparables are seldom perfect comparables and are selected as the closest comparables to the tested party by virtue of availability of data. Since median represents 50% of the observations in the set, it is a reliable indicator of the margins earned by the comparables, considered appropriate to gauge the performance of the industry. In this case, the median of 7.40% can be considered to be the arm’s length price.
Therefore, the tolerable limit requires the median to be in the range of 0.88% [i.e. ((100+4.00)*97%) – 100] and 7.12% [i.e. ((100+4.00)*103%) – 100], for the transfer price at which the margin is earned to be at arm’s length. In this case, since the tested party earns a margin of 4%, and the median is 7.40%, the median falls outside the tolerable limit of 3% (i.e. Maximum 7.12%) from the transfer price and the income earned by the tested party would be adjusted to the median of 7.40% by the revenue authorities. Thereby, the companies can use the median as the arm’s length price to set a transfer pricing policy to be well within the resultant arm’s length range.
At this juncture, the authors would like to highlight that the revenue authorities of several nations including China, Austria and others use Median as the arm’s length price. Few countries even accept the arm’s length price to be lower than the median on fact specific cases.
Going by the historical trend with regards to the Indian scenario, if the comparable sets adopted by the TPOs for the Information Technology enabled Services (ITeS) segment is to be considered, then the resultant statistical figures are displayed in Figure 2.
Figure 2: Interquartile Range of the ITeS Set adopted by the Transfer Pricing Officers
| Particulars |
Financial Year
| |||||
2004-05
| 2005-06 | 2006-07 | 2007-08 | 2008-09 |
2009-2010
| |
| Comparables | 9 | 13 | 27 | 20 | 8 | 10 |
| Arithmetic Mean (%) | 24.68 | 24.00 | 30.21 | 24.73 | 25.04 | 26.86 |
| Median (%) | 24.88 | 20.86 | 27.31 | 21.48 | 24.14 | 24.48 |
| Interquartile Range (%) | 17.02 – 29.85 | 16.03 – 29.01 | 12.62 – 35.25 | 9.27 – 36.92 | 17.34 – 42.06 | 21.36 – 40.10 |
| Min – Max Range (%) | 2.81 – 45.62 | 7.72 – 48.03 | (13.55) – 113.49 | (13.29) -96.66 | (16.63) – 57.50 | (12.31) – 55.97 |
Further, the adoption of median as the arm’s length price may itself be contested by the taxpayers especially in the cases of abnormal circumstances which might once again spur prospects of litigation.
It is important to note our Minister of Finance has not altogether dispersed off the concept of the arithmetic mean and stated that, it shall continue to apply where number of comparables is inadequate. The subjective view of adequacy could itself be under question. The consolation however is that the data is still under analysis and appropriate rules shall be prescribed once finalized.
This only provides credence to the fact that transfer pricing is not an exact science and there might be instances where application of interquartile range may also not be feasible. Nonetheless, with the objective of conciliating with the investors, the step to align the regulations per the best available practices is undoubtedly right.
[1] 2012 global transfer pricing tax authority survey
[2] http://www.hmrc.gov.uk/manuals/intmanual
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