Transfer pricing is a relatively new concept in India and like all new regulations, requires a reasonable time to mature. There are certain fundamental measures, which the Indian government could take to help rationalise the TP regulations.
Need to introduce APAs
Advance pricing arrangements (APAs) should be introduced to provide certainty to taxpayers, particularly foreign multinational companies (MNCs). At the moment a taxpayer has to wait for almost three years from the completion of any cross-border transaction with a related party, for a verdict from the Indian Revenue on the deal's transfer pricing implications. This uncertainty in matters relating to transfer pricing has pushed back several large investment proposals of foreign MNCs in India, thus marking a negative impact on the Indian economy.
APAs would be most useful for MNCs (both inbound and outbound) undertaking complex transactions, for example involving licensing or exploitation of high-end intangibles, for which identification of routine comparables would be difficult and transfer pricing policies would often be set through niche profit split analyses.
Apart from that, APAs would also be useful for deciding transfer pricing models for contract/toll manufacturers working under captive arrangements, not just for an upfront ruling on the percentage of mark-up on costs, but also on the composition of the cost base with reference to which the mark-up is calculated, for example on full costs or value added expenses. These aspects are extremely critical for MNCs setting up captive contract/toll manufacturers in any country and with India ideally positioned as the next preferred global hub for manufacturing, an APA mechanism would bring much relief to MNCs.
Only public information
The transfer pricing regulations should specifically provide that the transfer pricing officer (TPO) may use only data available from the taxpayer, and in the public domain, either at the time of setting of the prices of any transaction with a related party or if not, then at the time of preparing the documentation for the relevant financial year. The deadline for preparing the documentation is the September 30 after the closure of the transaction. The law should ban the prevalent practice of TPOs of using data available at the time of audit conducted three years after the end of the financial year in question, in spite of the mandatory cut-off date of September 30.
Multiple year data and arithmetic mean
The Indian transfer pricing regulations require a comparability analysis to be based on data pertaining to the year in which a taxpayer undertakes the international transactions with related parties (current-year data). However, the taxpayer may also use data from the previous two years, where such past years’ data reveals facts that could influence the determination of transfer prices of the current year. During transfer pricing audits, TPOs have generally tested the taxpayers' results using only current-year data from comparable companies, ignoring earlier years’ data.
The issue takes on further importance because under the Indian transfer pricing regulations, arm’s length price of an international transaction is determined having regard to the arithmetic mean of all the comparable transactions with a limited flexibility of a 5% range around the mean. Within an industry, a comparable company may incur losses or earn super profits in any one year because of a variety of reasons. However, its business may stabilise over a few years and considering data relating to multiple years of its operations may provide a more correct picture of its profitability.
On the contrary, if the Indian regulations had adopted median and interquartile range as statistical measures of arm’s length price and range respectively, the extreme values or outliers might not have a significant negative impact. In most cases, they would have been excluded, unlike in the case of arithmetic mean, even though the calculation of median and interquartile range would have been based on current (single) year data.
Having regard to this, the transfer pricing regulations need to be amended to either explicitly state the use of multiple year data in conjunction with an arithmetic mean approach to determine arm's-length price to avoid any unwarranted litigation. Or, to align it with international best practices, they need to be amended to revisit the entire structure altogether and adopt the concept of median and interquartile range as statistical measures along with the use of multiple year data .
Rahul Mitra, partner (executive director), tax & regulatory services - transfer pricing, PricewaterhouseCoopers, India
