In recent years India has been viewed as an attractive and dynamic investment destination, thereby seeing an increased presence of multinational companies (MNCs) and a consequential increase in cross-border trade. This has amplified the vigilance by the Indian Revenue in matters relating to transfer pricing. In the last round of transfer pricing audits conducted by the Revenue, which completed in October 2009, adjustments were made to almost 45% of the cases picked up for scrutiny, resulting in an aggregate transfer pricing adjustment of approximately $2.3 billion across the country.

With this backdrop, it is worth evaluating certain fundamental concepts that are quite often overlooked in the course of a transfer pricing audit. The audit process is envisioned to undertake a detailed scrutiny of the cross border intra-group transactions in order to ascertain their arm's length nature. However, in practice, instead of examining the underlying basis, profitability is often adopted...