Arm’s Length Price (‘ALP’)?

As per the Organisation for Economic Co- operation and Development (‘OECD’) Transfer Pricing Guidelines Arms’ Length Price means a price, at which transactions between persons other than associated enterprises are carried out in uncontrolled circumstances.

As defined by section 92F of the Income Tax act, 1961 (“the Act”), an Arm’s-length price is a price that is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions. Section 92C of the Act prescribes various methods for the determination of the arm’s-length price  and provides  that such a price will be calculated using the most appropriate method.

1. Comparable Uncontrolled Price Method (CUP)
2. Resale Price Method (RPM)
3. Cost Plus Method (CPM)
4. Profit Split Method (PSM)
5. Transactional Net Margin Method (TNMM)
6. Such other methods as may be prescribed by the

This article deals with the subject of anomalies / issues in determining Arms’ Length Price (ALP).

The Most Appropriate Method

Under the Income Tax Act, 1961 [“the Act” for short] no particular method has been accorded a greater or lesser priority. The most appropriate method for a particular transaction shall be determined by the assessee on the bases of the nature of the transaction, class of transaction, associated persons and functions performed by such persons, as well as various other relevant factors. The Assessee has to identify and understand the intra-group transactions, identify the characteristics that would make a particular transaction or function, make appropriate adjustments to the comparables, etc. while selecting the most appropriate method.

On this it has been held that the onus to select and justify the most appropriate method for calculation of ALP lies on the assessee, by the Hon’ble Income Tax Appellate Tribunal [“the ITAT], Mumbai in the case of Kodak Polychrome Graphics (I) P. Ltd [ITA No.1577 / Mum / 2009]. If the Revenue authorities are of the opinion that the ALP was not applied to the transaction or that the assessee did not maintain / produce adequate and correct documents / information / data, the total taxable income of the assessee may be recomputed after a hearing opportunity is granted to the assessee. While the revenue can challenge the selection of the most appropriate method, the method could not be discarded in preference over other methods, unless the revenue authorities could demonstrate the fallacies in the application of standard methods. (MSS India [ITA NO.393/MUM/2007].

On change of a method already adopted / followed by the assessee recently, in case of Aquity Solutions India Pvt Ltd [ITA NO.1161/ MUM/2019, ITA NO.1351/BANG/2011 and ITA

NO.1644/BANG/2012] ITAT, Mumbai held “there was no bar under the Act or Rules restricting assessee to change method of determining ALP but also elucidated that change of method should be for bonafide reasons and not in an arbitrary manner just to circumvent adjustment proposed by the TPO”

The various methods prescribed under the Act, have their own specific application and consequently have issues specific to their application. In this section we have tried to identify certain issues / anomalies each method wise while determining the ALP. They are as follows:

1. Comparable Uncontrolled Price Method (CUP)

Under this method to determine ALP the price charged for property or services transferred in a controlled transaction is compared to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances. The CUP method may be based on either “internal” comparable transactions or on “external” comparable transactions. However, while applying CUP method for determining the ALP it is required to be compared with actual sales and purchases with unassociated enterprises or transactions between unassociated enterprises. The Hon’ble ITAT Mumbai in the case of Redington India Ltd [ITA No.808 / Mds / 2011] held that CUP analysis should not necessarily be done on the basis of list price especially when the prices charged by Assessee are lower than the list price for both associated as well as non-associated enterprises. Further, in the case of Arvind Mills Ltd [ITA 1304 / Ahd /2006] Hon’ble ITAT, Ahmedabad observed that the product comparability cannot be the sole basis for application of CUP method. Even minor differences in contractual terms or economic conditions, geographical areas, risks assumed, functions assumed, etc. could  affect the amount charged in an uncontrolled transaction. As such, while applying CUP, it is essential to note that its not just the similarity of the product but also all other factors which could affect the price.

In an interesting judgement, it was observed by the ITAT, Mumbai that for benchmarking royalty, CUP is the Most Appropriate Method since in that case royalty was not linked to profit [Ref. Syngenta India Limited [ITA 2977 / Mum /2006]. However, in another case, the ITAT, Mumbai has held that CUP method is not applicable in benchmarking royalty in the absence of data relating to uncontrolled transactions [Ref: Cabot India Ltd. vs. Dy. Commissioner of Income-tax I.T.A. No. 6622/ Mum/2009] 

2. Resale Price Method (RPM)

Rule 10B (b) lays down that RPM may be applied for transactions of purchase of goods or services from AE which are then resold to unrelated parties. The ITAT observed that in the case of an assessee performing pure distribution functions without any value addition on sale of traded goods it is appropriate to apply the RPM method [Ref: Textron India Pvt Ltd vs Dy. Commissioner of Income Tax [IT(TP)A No.2972/Bang/2018]. Also, the ITAT, Delhi in the case of Burberry India Pvt Ltd v/s ACIT [I.T.A. No. 758/Del/2017] has held that incurring high advertising and marketing expenses by the assessee does not in any manner affect the determination of ALP under the RPM. Further in the case of Celio Future Fashion P. Ltd [I.T.A. No. 1928/Mum/2016 it has been held in the case of an Assessee who is a distributor of Men’s wear imported from the AE, that RPM is the Most Appropriate Method and merely because high advertising / marketing expenses were incurred by it did not lead to any value addition justifying application of another method. The ITAT, Mumbai has in the case of Mattel Toys (I) Pvt. Ltd vs DCIT [I.T.A. No. 2476/Mum/2008] observed that product similarity is not a vital aspect for RPM, but operational comparability has to be seen.

3. Cost Plus Method

Cost Plus Method is prescribed under clause (c) of Rule 10B. Under this method, the Arm’s Length Price is determined by applying normal gross profit mark- up arising from similar uncontrolled transactions, after adjustment for functional and other differences, to the direct and indirect costs of production incurred by the assessee on its transaction. It is mostly applied to manufacturing or assembling activities and relatively simple service providers. It has been observed that CPM is the most appropriate method where the transactions involve commodity-type products, but the differences between the products are minor [Ref: DCIT vs GE BE Pvt. Ltd.- ITA No.815/Bang/2010].

However, the CUP method is not suitable in the case of the manufacturer who owns valuable intangibles, performs R&D activities, and generally has operations that are more complex than those of the sales company

4. Profit split method (PSM)

The Profit Split Method is applicable when the transfer of unique intangibles is involved or in multiple international transactions which are so interrelated that they cannot be evaluated separately for the purpose of determining the arm’s length price of any one transaction. This method can be applied to the cases where both sides of the controlled transaction contribute valuable intangible property to the transaction and cases involving highly interrelated transactions that cannot be analyzed on a separate basis. It is to be noted that it has been held by the ITAT that this method of ALP determination cannot be applied for Royalty benchmarking as there was an absence of an associated enterprise’s role in the assessee’s profit-making [Ref: Toyota Kirloskar Auto Parts Pvt Ltd [IT(TP) A No.1915/Bang/2017]. In the case of Infogain India Pvt Ltd [ITA No. 6134/Del/2012], the ITAT Held that PSM cannot be rejected as a method merely on the basis that it may be difficult to identify external benchmarks for allocation of profits amongst entities.

5. Transactional Net Margin Method (TNMM)

Transactional Net Margin Method (TNMM) is provided in Rule 10B(1) (e). Under this method, the net margins of companies are compared to analyze if the related party transactions have been undertaken on arm’s length basis. Transactional Net Margin Method is most commonly used by assessees for practical reasons as the method often provides a useful check on the accuracy and reasonableness of the traditional transaction methods or is used to supplement these methods. It is also easier to find comparable in applying this method. The TNMM is used to analyse transfer pricing issues involving tangible property, intangible property or services. It may be applied when one of the associated enterprises employs intangible assets, the appropriate return to which cannot be determined directly.

The Hon’ble ITAT Bangalore in the case of ITO v/s Simulation  Technologies Pvt Ltd [IT(TP)A No.100/Bang/2014] observed that broad functional similarity is sufficient for determining ALP under the TNMM method. Opined that the functions performed need not be identical. Remarked, “A broad similarity, in our view, would suffice for the purpose of picking up a comparable”. Further, the Hon’ble ITAT Mumbai in the case of Golawala Diamonds [I.T.A. No. 2346/ Mum/2006] observed that the entity level margins need not be considered for ALP computation under the TNMM method. In yet another judgment, the ITAT, Mumbai reversed the action of the TPO in determining Nil ALP for Royalty payments observing that receipt of technical assistance by the Assessee from the AE justified royalty and it could not be said that the same is not payable [Ref: Dow Agro Sciences ITA No.1051/ Mum/2015]. This issue of jurisdiction of the TPO to determine ALP at Nil is also discussed in subsequent paragraphs.

6. Such other methods as may be prescribed by the board.

Section 92C of the Act provides that CBDT may prescribe any other method for the determination of ALP. Accordingly, Rule 10AB was introduced w.e.f. 01.04.2012 as per which, such other method for determination of the arm’s  length price in relation to an international transaction shall be any method that takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts. In Toll Global Forwarding India Pvt Ltd [I.T.A. No. 5025/Del/10] the Hon’ble ITAT observed that ‘the methods of determination of arm’s length prices have to be essentially implemented in a reasonable and pragmatic  manner so as to achieve its laudable objectives without any collateral damage. Further, in Global One India Private Limited [ITA No. 5571/Del/2012] it was ruled that if the PSM, as applied by the Taxpayer, did not fall within the strict definition of PSM provided in Rule 10B(1)(d), then the same could be considered as “The Other Method”. In the case of Tally Solutions Private Ltd [ITA No. 1235/Bang/2010] use of the ‘Excess Earning Method’ for determining arm’s length price using ‘discounted cash flow’ for the sale of ‘intellectual property rights’ was upheld by the ITAT.

Other issues in the determination of ALP:

1. If the variation does not exceed 1% of the wholesale price and 3% in other cases of international or specified domestic transactions, then the actual transaction price shall be taken as ALP as notification CBDT Income Tax Notification 124/2021 29/10/2021: Transfer Pricing (ALP) Variation Tolerance Limits AY 2021-22.
2. The Hon’ble ITAT Delhi in the case of McCain Foods India Pvt Ltd [ITA No. 5597/ Del/2018] has held that disallowance u/s 40(a)(ia) and 92CA(3) cannot operate simultaneously as this would lead to double taxation. It was observed that liability u/s 40(a)(ia) to deduct the requisite tax at source and such deduction was liable to be added to the assessee’s total income. It was further observed that if ALP was determined by TPO as NIL, it also amounted to an addition to the assessee’s total income again.

3. In another case, it was observed that overruling the  wrong  application of a method doesn’t mean ruling out the selection  of that method  as If the wrong application of a method is corrected then the same could be selected again as the most appropriate method. However, at the same time, the Hon’ble ITAT rejected the Miscellaneous Application (MA) seeking directions to the TPO to adopt only a specific method [Ref: Carraro India Private Limited vs DCIT M.A. No.01/PUN/2020].
4. No adjustment can be made by the TPO on the presumption of international transaction without any tangible evidence to prove so [Ref: Whirlpool of India Ltd [ITA 610/2014, Hon’ble Delhi High Court following Maruti Suzuki – ITA 110 of 2014 ]
5. It has also been held that recharacterization or non-recognition of a transaction fully or partially, is not permissible for the Revenue Authorities. Recharacterizing the transaction of Share Application Money as a loan transaction was rejected by Hon’ble Delhi High Court in CIT vs Alpex Exports – (2014) 361 ITR 29. In the case of DIT v/s Besix Kier Dabhol – (2012) 210 Taxman 151 (Bombay) Hon’ble Bombay High Court rejected the re-characterization of debt as equity. In Aegis Limited [ITXA 1248 OF 2016] re-characterization of investment in preference shares as to loan was not accepted by the Hon’ble Bombay High Court
6. Hon’ble Bombay High Court CIT vs Lever India Exports Ltd. – ITXA 1306 of 2014 has held that expenses cannot be rejected by the It was remarked that, “… It is not part of the TPO’s jurisdiction to consider whether or not the expenditure which has been incurred by the respondent- assessee passed the test of Section 37 of the Act and/or genuineness of the expenditure… The jurisdiction of the TPO is specific and limited i.e. to determine the ALP of an International Transaction in terms of Chapter X of the Act read with Rule 10A to 10E of the Income Tax Rules.. Therefore, the adhoc determination of ALP by the TPO dehors Section 92C of the Act cannot be sustained.”. Hon’ble Karnataka High Court in the case of Luwa India Pvt. Ltd. [ITXA No. 296/Mum/2017] has taken the same view following the ruling of the Hon’ble Bombay High Court.

7. Further, ad-Hoc determination of ALP by TPO is not sustainable in Law as ruled in CLSA India Private Limited vs DCIT [ITA No.6748/Mum/2017].
8. In the case of Indo-American Jewellery [I.T.A. 6194/Mum/2008] ITAT, Mumbai held that the external comparables selected by the assessee were from the public database and the assessee had complied with all the necessary rules and had followed a detailed search process while making an analysis therefore the transfer pricing study of the assessee and ALP of international transactions determined on the basis of study simply cannot be rejected without any cogent reasons by the TPO.
9. It has been held that a comparable should not be rejected simply on the ground that its margin is extremely high (or low) in relative comparison to the data pertaining to its [Ref: JCIT vs Amway India Enterprises Pvt. Ltd. I.T.A. No. 2833/ DEL/2018].
10. Foreign Associate Enterprises as comparable has been accepted in Ranbaxy Laboratories Ltd [IT(TP)A 1782/Del/2014]. Recently Madras High Court in the case of Virtusa Consulting Services Private Limited [T.C.A.No.996 of 2018] held that “the findings rendered by the TPO, DRP and the Tribunal foreclosing the assessee’s claim to refer to the foreign AEs as the tested party is legally not sustainable.” However, for selection of the comparable, in the case of Intervet India P. Ltd [39 SOT 93 (Mum)],  the ITAT has made an observation that the geographical contiguity of two countries need not mean similar economic and market conditions.

11. In the case of Galaxy E Solutions India Pvt Ltd [IT(TP)A No.389/Bang/2021] ITAT, Bangalore made an observation that “… there is no principle of estoppel that applies in determining tax ”
12. The TPO cannot question the assessee’s business decision. It was also held that it was not within TPO’s purview to question the benefit from royalty payment as held by the Hon’ble Bombay High Court in SI GroupIndia Limited [ITXA 965 of 2017]
13. Hon’ble Bombay High Court in the case of WIKA Instruments India Pvt Ltd [ITXA 1141 of 2016] has ruled that there is no bar against the assessee rejecting its own comparables.

14. The Hon’ble Delhi High Court on mere disagreement on the application of one or other methods for determining ALP between the assessee and the revenue authorities opined “…the mere circumstance of a disagreement either between the assessee and the Revenue authorities or amongst the Revenue authorities in the application of one or other methods for determining ALP ipso facto does not constitute question of law. This, however, not to say that if in a given case the aggrieved party is able to show that the rule applied has led to distortion or prejudice as the case may be, the question of law does not arise” in the case of McCain Foods India Pvt Ltd [ITXA 965 of 2017] 

Conclusion

Despite Transfer Pricing Law being there for more than 20 years, the primary aspect of determining ALP keeps evolving day in and day out. It is, therefore, felt that the entire process be streamlined. Further, it is preferable that just as it is done in service tax, a specific method/ rate/margin be prescribed for certain common transactions which are industry-specific / transaction-specific.

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