Economic analysis – Transfer Pricing

Characterization of the transacting parties

  • For applying the above methods, following factors needs to be analyzed with respect to the transactions
  • Specific characteristic of the property transferred or services rendered
  • The functions performed taking into account assets employed and risks assumed by the respective parties.
  • Characterization of entities based on functions performed by each associate enterprise, assets employed by them to carry out the functions and risks assumed by each enterprise in carrying out the functions.
  • Conditions prevailing in the market in which the respective parties operate, laws of the territory, labour and capital markets level of competition etc. are to be considered for such analysis
  • Rule 10B provides that comparable transaction data should relate to the financial year in which the international transaction has been entered into.
  • If CPM, RPM or TNMM is the MAM, then the data of the uncontrolled transaction to be used shall be
  • The data relating to current year
  • The data relating to the FY immediately preceding the current year, if the data relating to the current year is not available at the time of furnishing the return of Income.
  • However, where the data relating to the current year is subsequently available at the time of determination of ALP during the course of assessment proceedings then such data shall be used.
  • Further, if the data for the current year is available but is not functionally comparable, that particular entity should not be used even if previous year is comparable.
transacting parties
  • Tested party and profit level indicator are main parameters in identifying the comparable transaction and the profit margin that has to be compared.
  • This also helps in identifying the Most Appropriate Method

Tested Party

  • There are various participants in an international transaction. In a transaction of say purchase and sale of goods, there is a purchaser and there is a seller.
  • Similarly, in case of services, there is a service provider and a service receiver. So, of the parties in the controlled transaction, the party whose transaction is benchmarked / compared is known as the tested party.
  • In order to find comparables, one party has to be considered as tested party.
  • The following attributes are relevant for choosing the tested party namely:
  • Profitability / pricing of the tested party can be verified based on appropriate data
  • Reliable data can be obtained within reasonable timeframe
  • If the data requires reasonable adjustments, such reliable adjustment can be made.
  • It should be the least complex entity in the transaction.
  • It does not own valuable / significant intangibles

Profit level Indicator

  • Profit level indicator is the ratio of profits earned on an appropriate measure such as sales, costs, capital employed etc.,
  • In CPM, RPM which component should be in the denominator is fixed i.e in case of CPM, it is total cost and in case of RPM it is sales or turnover, etc. In TNMM, it depends on the transactions.
  • The denominator has to be chosen in such a way that it has to be independent of controlled transactions.
  • For example, if the entity has sales to AEs, then the denominator is cost and if the international transaction is purchases, then it would be sales.
  • However, in real situations, an entity may have both purchase / sales or income / expense transactions with its AEs. What would be the denominator in such situations?
    • The least tainted transaction i.e sales or cost would be considered in the denominator.
    • This PLI is applied across all the comparable companies to measure to arrive at ALP.

Question

In order to determine the most appropriate method and choose comparables for international transaction, which enterprise would be selected as the tested party?

  1. Always the enterprise in India
  2. Always the foreign AE
  3. Either of the participants
  4. Any uncontrolled enterprise

Answer c.

Correct. In order to find comparables, one of the AEs has to be considered as tested party. Generally, the enterprise whose profitability can be verified based on appropriate data and which is least complex and does not own significant intangible is considered as the tested party.

Question

Profit Level Indicator (‘PLI’) means

  1. Break-even point
  2. Profit distribution between AEs
  3. Ratio that measure relationships between profits and cost incurred or resources employed, or revenue earned or any other appropriate parameter

Answer c.

PLI is a ratio that measure relationships between profits and cost incurred or resources employed, or revenue earned or any other appropriate parameter. Numerator is often operating profit and the denominator could be either revenue, cost, capital employed etc.,

Question

What component would be representative in the denominator of the PLI in the case of contract manufacturer who purchases the components and sells the finished goods to its AEs.

  1. PLI denominator would be sales since it would be the dependent transaction
  2. PLI denominator would be capital employed since it would have no relationship to controlled transaction.
  3. PLI denominator would be cost since sales is done to AEs and PLI it would be the highest tainted component
  4. PLI denominator could be value added cost or conversion cost

Answer d.

Since the purchase cost and the sales revenue are both tainted since both are from / to AEs, the conversion cost which would largely be with uncontrolled parties could be used as the PLI denominator.

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