0

Login

HOME ABOUT TAXSUTRA SUBSCRIPTION LIVE COVERAGE SPECIAL COVERAGE

SC:Upholds HC-order confirming deletion of

Advanced Search Search By Issues
guarantee fee TP-adjustment for Glenmark Pharma

EXPERT Capacity utilization adjustment in transfer pricing – a

CORNER mathematical fallacy or myth? - Part I
February 19,2018 Rate this story:

Hide story

Intra-group services benchmarking

– Resolving the stalemate Rahul K Mitra (Partner, KPMG
S C Tiwari, Member (Dispute
India)
Resolution Panel)-1, Mumbai

Given that transfer pricing (TP) is not an exact science, taxpayers and Revenue Officers often end up spending lot
of time in trying to make economic adjustments to the arms or financial results of either the taxpayers or
comparable companies, in order to arrive at an optimal arm’s length price (ALP), since, as people tread on the path
of comparability analyses, they find that different people have arms of varying lengths. If one makes an attempt to
compare the characteristics of two diametrically opposite individuals like Sachin Tendulkar and Joel Garner; and
View all then grapple with either trying to shorten the arms of Joel Garner or lengthen those of Sachin Tendulkar, in order
to fallaciously obtain parity, then, to put it in the words of Gladstone, the attempt may either be a catastrophic
disaster or disastrous catastrophe, depending upon whether the very attempt to select the said two stalwarts for
comparison can be termed as a disaster or catastrophe in the first place, such that the subsequent exercise of
making adjustments to their arms become a mere fallacy or meaningless exercise.

The type of economic adjustment, which has caught maximum amount of attention in India, is the one relating to
capacity utilization. Taxpayers and Revenue Authorities, particularly taxpayers, have resorted to making such
adjustment in order to moderate the profit margins of comparable companies on the ground that there exist
significant disparity between the capacities utilized by the taxpayers and comparable companies chosen for
TAX determining ALP, generally under transactional net margin method (TNMM), which compares net profits of

RING
taxpayers and comparable companies. Tax Tribunals across the country have taken divergent stands in matters
relating to granting or otherwise of adjustment on account of capacity utilization.

This article is aimed towards a dissertation on the entire concept of capacity utilization, which, very humbly
Comparables selection issue in
stated, appears to be more of a mathematical fallacy, often being several leagues away from the very basics or
transfer pricing - Dying a slow
fundamentals of TP. I shall address the issue as the article would unfold itself.
death?
It is the golden rule of TP that attempt should be made to select comparable companies with characteristics as
View all close to the “tested party” as possible, since it is always advisable to minimize the need or necessity of making
economic adjustments for ironing out material differences between the comparable companies and the “tested
party”, in order to achieve reliability in the overall exercise of comparability analysis.

INTERNATIONAL RULINGS
UK Upper Tribunal: Confirms TP-
applicability on Bonus Share issue to
AE; Distinguishes Vodafone India
ruling
Sometimes, resorting to economic adjustments, even after choosing the best available comparable companies,
become inevitable. For example, making working capital adjustment in order to neutralize the impact on profit
margins of the “tested party” and comparable companies, arising as a result of different levels of working capital,
vis-à-vis funds being locked, therein, is a very crucial and important economic adjustment to be carried out for
determining the ALP. Similarly, needs may arise to make adjustments to profit margins, for comparable
companies, which otherwise bear closest resemblances to the “tested party” as per comparable analysis carried
out with most meticulous of precisions, having due regard to limitation of data available in databases, yet may
differ with respect to some important attributes as compared to the “tested party”, e.g. different levels of value
additions in case of contract manufacturers; or different levels of intensity of functions in case of distributors,
where necessary economic adjustments may be carried out, particularly with reference to regression analysis.
However, for the reasons discussed in detail in this article, the author feels that adjustment for capacity utilization
actually stands on an altogether different footing; and actually does not have a place in proper application of the
principles of TP. From reported rulings of Tax Tribunals over the years, it is noticed that taxpayers have resorted to
capacity utilization adjustments in two categories of cases, again, as discussed above, with different rates of

View all success.

First category – selection of wrong “tested party”, in case of entrepreneur

DOMESTIC TP
1. The first category relates to scenarios where taxpayers have taken entrepreneurs as “tested parties”; and
thereafter tried to cover up losses or meagre profits of them, being otherwise caused due to normal vagaries
and attributes of entrepreneurship and economic conditions of the country, through making of economic
adjustments, including adjustment on account of capacity utilization, with reference to the results of
comparable companies, selected for benchmarking analysis under TNMM, who are also entrepreneurs, on
the ground that the taxpayers’ capacity utilizations were far lower than those of comparable companies; and
accordingly, the taxpayers had to incur significant amount of additional fixed overheads, as compared to the
comparable entrepreneurs, being one of the justifications for suffering losses or earning meagre profits.
2. I have noted that such scenarios have prevailed both in the contexts of outbound full-fledged Indian MNE
entrepreneurs; and also inbound entrepreneurial licensed manufacturers, being subsidiary companies of
foreign MNEs, generally being OEMs. Incidentally, people associated with the subject of TP would realise
that there is no difference between the said two categories of taxpayers, both from the perspectives of
optics and substance.
3. Now, very honestly, this category of cases does not even merit a discussion, since the problem is extremely
fundamental and lies in the very approach of selecting the wrong entity as the “tested party”. It is a cardinal
principle of TP that the least complex entity in a particular transaction needs to be selected as the “tested
party”. I am not going into the detailed reasoning of the theory, due to brevity of space; and further being the
most elementary aspect of TP. Thus, in case the taxpayer in India has the attributes of an entrepreneur,
whether full-fledged, in the case of an outbound Indian MNE, or under a license, in the case of an inbound
foreign MNE, it cannot be selected as the “tested party” in the first instance, for being subjected to
comparability analysis. Ideally, the foreign associated enterprise, namely the distributor of products in the
case of an outbound Indian entrepreneurial MNE; or supplier of raw materials/ components or distributor of
products in the case of an inbound entrepreneurial licensed manufacturer subsidiary of a foreign MNE, being
the most common form of transactions, would need to selected as the “tested party”.
4. In case one proceeds to carry out comparability analysis with such entrepreneurial entities, it would amount
to carrying out a surgery or operation upon the friend of a patient, where neither the operation would be
successful nor the patient cured. Now, while operating upon the friend of the patient, it may happen by
chance that the surgeon diagnoses any type of ailment within such friend, which he cures through the
operation; and feels that the problem is solved and the disease cured, since he is still under the illusion that
the friend was the actual patient. The patient carries the ailment with itself for facing a life threatening
moment going forward, namely to die another day. In case, the doctor is not able to detect any definite
ailment within the friend on the operation table, which he could have otherwise cured through an operation,
he unsuccessfully fiddles around with the various anatomies of the friend, again under the illusion of he
being the actual patient, only to announce that the patient is incurable; and needs to die; or in other words,
suffer a TP adjustment.
5. Lest the reader gets bored with rhetoric, this is what precisely happens when one attempts to carry out
economic adjustments, including that for capacity utilization, on the wrong “tested party”, where the
taxpayer, depending upon sheer luck or chance; and by playing upon the level of receptiveness of the
Revenue and Judiciary, may either escape unscathed or face a TP adjustment. There is no remedy for this
self-inflicted ailment, as the entire approach towards TP under the first category of cases is wrong; and
taxpayers would actually need to take the first and initial step of putting their houses in order, unless the Tax
Tribunals, in their wisdom and goodness, wish to crack the whip and force both taxpayers and Revenue
Officers to fall in line. At the end of the day, the entire exercise by taxpayers and Revenue Officers under this
scenario, involving the fallacious approach, is a mere game with numbers, which has nothing to do with TP
whatsoever.

Click here to read Part II of the article.

Post a Comment
Top

Copyright © TAXSUTRA All rights reserved Sitemap Privacy Policy Disclaimer