Selection of Overseas AE as Tested Party
CA. Rajat Sambhaji Powar
The author is a member of the Institute. He can be reached at rajatpowar00@gmail.com and eboard@icai.in
“Selection of the Tested Party is one of the most crucial steps in the transfer pricing analysis and forms the base for the benchmarking analysis. Selection of Tested Party directly affects the selection of the ‘Most Appropriate Method’ and the comparable. Hence, great caution has to be exercised while selecting the tested party as the choice of a wrong tested party may distort the benchmarking analysis. The Indian Transfer Pricing Regulations do not provide any guidance in respect of selection of tested party. However, as per Organisation for Economic Co-operation and Development (OECD) and UN Transfer Pricing guidelines, broadly speaking, the least complex entity for which the most reliable data is available, and which requires fewer adjustments is to be selected as tested party. In many cases, selection of overseas AE as a Tested Party has been questioned by the tax authorities despite meeting the required conditionalities. Read on...”
The Indian Transfer Pricing Provisions
The Indian Income Tax law is silent on the aspect of selection of overseas AE as tested party.
OECD TP Guidelines1
Paragraph 3.18: “...The choice of the tested party should be consistent with the functional analysis of the transaction. As a general rule, the tested party is the one to which a transfer pricing method can be applied in the most reliable manner and for which the most reliable comparables can be found, i.e., it will most often be the one that has the less complex functional analysis.”
UN Transfer Pricing Guideline2
“Paragraph B3.5.1.2: The tested party normally should be the less complex party to the controlled transaction and should be the party in respect of which the most reliable data for comparing the results of similar independent transactions is available. Either the local or the foreign party may be the tested party. If a taxpayer wishes to select the foreign associated enterprise as the tested party, it must ensure that the necessary relevant information about it and sufficient data on comparables is available to the tax administration in order for the latter to be able to verify the proper selection of the tested party and the accurate application of the transfer pricing method.”
UN Transfer Pricing Guidelines (Indian-Country Practice)
“Paragraph 3.2.3: …..In most cases, the Indian entity is taken as the tested party and Indian comparables are used. If the foreign associated enterprise is the less complex entity, it is taken as the tested party.”
Hence, it can be inferred from the above international guidelines that a selection of overseas AE as a tested party is an internationally accepted practice. However, the Indian judiciary appears to be divided on this point.
Cases where Overseas AE was not selected as a Tested Party
Onward Technologies Limited vs. DCIT3
“The modus operandi of determining ALP of an international transaction under this method is that firstly, the profit rate earned by the assessee from a transaction with its AE is determined (say, profit A), which is then compared with the rate of profit of comparable cases (say, profit B) for ascertaining as to whether profit A is at arm’s length vis-a-vis the profit B. If it is not, then the transfer pricing adjustment is made having regard to the difference between the rates of profit A and profit B. The rate of profit of comparable cases (profit B) may be computed from internally or externally comparable cases, depending upon the FAR analysis and the facts and circumstances of each case.
Thus, the calculation of profit B may undergo change with the varying set of comparable cases. However, in so far as calculation of profit A is concerned, there cannot be any dispute as the same has to necessarily result only from the transaction between two or more associated enterprises, as is the mandate of sections 92 read with 92B in juxtaposition to rule 10B. The natural corollary which, thus, follows is that under no situation can the calculation of ‘profit A’ be substituted with anything other than from the international transaction, that is, a transaction between the associated enterprises.
So, it is the profit actually realized by the Indian assessee from the transaction with its overseas AE which is compared with that of the comparables. There can be no question of substituting the profit realized by the Indian enterprise from its Overseas AE with the profit realized by the Overseas AE from the ultimate customers for the purposes of determining the ALP of the international transaction of the Indian enterprise with its Overseas AE. The scope of TP adjustment under the Indian taxation law is limited to transaction between the assessee and its Overseas AE. It can neither call for also roping in and taxing in India the margin from the activities undertaken by the Overseas AE nor can it curtail the profit arising out of transaction between the Indian and Overseas AE at arm’s length.
The contention of the Id. AR in considering the profit of the Overseas AE as ‘profit A’ for the purposes of comparison with profit of comparables, being ‘profit B’, to determine the ALP of transaction between the assessee and its Overseas AE, misses the wood from the tree making the substantive section 92 otiose arid the definition of ‘internal transaction’ u/s 92B and rule 10B redundant. This is patently an unacceptable position having no sanction of the Indian transfer pricing law. Borrowing a contrary mandate of the TP provisions of other countries and reading it into our provisions is not permissible. The requirement under our law is to compute the income from an international transaction between two AEs having regard to its ALP and the same is required to be strictly adhered to as prescribed. This contention, is therefore, repelled.”
Other decisions which relied on the judgment of Onward Technologies Limited v. DCIT (Supra) are:
- Bekaert Industries (Pvt.) Ltd. v DCIT4
- CarraroIndia(Pvt.) Ltd.v. DCIT5
- AT & S India Pvt. Ltd.6
The essence of the judgments can be said to be as follows:
- As per the Indian Transfer Pricing law, for determining ALP of international transaction it is the profit of the Indian AE which is to be compared with the profit of comparable and in no case can this be replaced by the profit which the Overseas AE earns from its ultimate customer.
- The term Enterprise used in Rule 10B refers to Indian enterprises whose profits are to be benchmarked.
- If the overseas AE is selected as a Tested Party and profits of the overseas AE are considered to be more than ALP than as a corollary, it would result in the Indian Entity earning less profit than ALP and hence the object of the TP exercise will not be achieved.
Cases where Overseas AE was selected as a Tested Party
1. Ranbaxy Laboratories Ltd. v. Additional CIT, Range 15, New Delhi7
“58… The tested party normally should be the party in respect of which reliable data for comparison is easily and readily available and fewest adjustments in computations are needed. It may be a local or foreign entity, i.e., one party to the transaction. The object of transfer pricing exercise is to gather reliable data, which can be considered without difficulty by both the parties, i.e., taxpayer and the revenue. It is also true that the least of the complex controlled taxpayer should be taken as a tested party. But where comparable or almost comparable, controlled and uncontrolled transactions or entities are available, it may not be right to eliminate them from consideration because they look to be complex. If the taxpayer wishes to take overseas AE as a tested party, then it must ensure that it is such an entity for which the relevant data for comparison is available in public domain or is furnished to the tax administration. The taxpayer is not then entitled to take a stand that such data cannot be called for or insisted upon from the taxpayer.”
The above view has been followed in the following decisions:
- Mastek Limited v. Addl. CIT8
- ITO vs. WNS Global Services Pvt. Ltd.9
- Development Consultants (P.) Ltd. v. Dy. CIT10
- TNT India Pvt. Ltd. vs. ACIT11
- Almatis Alumina Pvt. Ltd12
Thus, as can be seen from the above judgments that various tribunals have allowed selection of the overseas AE as a tested party where the overseas AE was the least complex entity. The OECD/UN Transfer Pricing guidelines have been accepted in this regard. It is emphasised that “tested party” is the least complex entity for which the most reliable data is available and for which fewer adjustments are required.
Analysis
Sec 92, which forms the basis of the Transfer Pricing Regulation under the Income-tax Act, 1961, provides that ‘Any income arising from an international transaction shall be computed having regard to the arm’s length price’. Sec 92B specifies that international transaction must be transaction between two AEs, at least one of which is a non-resident. Further, Sec 92A which defines AE also does not make any distinction between an Indian AE and an Overseas AE. Thus, it can be said that Indian Income Tax law does not have any bar against selection of overseas AE as a Tested Party.
Selection of tested party is a very important step in functional analysis. After taking into consideration the FAR analysis, the entity which has a least complex functional profile and for which most reliable data is available is to be selected as tested party. In most of the cases, it would be a simpler entity making non-unique contributions and performing simpler functions. Hence, for such an entity performing a benchmarking analysis is easy as comparables may be readily available. In such a case, the complex entity receives a residual return after compensating the tested party at an ALP.
On the other hand, if a complex entity is selected as a tested party, performing benchmarking analysis is quite difficult in such a case, because the complex entity may be owning intangibles and making unique contributions for which comparables may not be readily available. Also, the profit of such an AE would be affected due to reasons other than Transfer Pricing. Hence, the results of the whole of TP exercise may be distorted due to this.
It is pertinent to note that in Transfer Pricing even though methods except for Profit Split Method are single sided method, yet it is the international transaction which is benchmarked. Even if one AE is selected as tested party and is subjected directly to transfer pricing analysis, indirectly the profit of the overseas AE would also be benchmarked as it would receive a residual return after compensating the Tested Party at an ALP.
Even, Sec 92 specifies that the income from the international transaction should be computed having regards to ALP. Even if it is found that the amount charged by the overseas AE is more than ALP, automatically the profit of the Indian AE would be less than ALP and there would be an adjustment in the hands of Indian AE. Hence, for the purpose of establishing that the international transactions have been entered at ALP there is no bar against selection of overseas AE as a tested party.
This view is also consistent with the OECD guideline and UN guidelines on Transfer Pricing. Moreover, in the Country Practice part of the UN Transfer Pricing guidelines, it is said that overseas AE can be selected as a tested party if it is the least complex entity.
This can be better understood with help of following examples:
Example 1: Overseas AE as Reseller & Indian AE as Principal
Consider an example where an overseas AE is a reseller and Indian AE is the principal. In such a case, overseas AE would be the least complex entity for which the data would be readily available and hence it should be selected as a tested party.
On the other hand, if the Indian AE is selected as a Tested Party, it must be making unique contributions for which comparables may not be readily available.
Moreover, if the Indian AE is selected as a tested party, it will not be possible to select RPM (Resale Price Method) as the Most Appropriate Method, which depending on the other factors can be selected as a MAM in case of overseas AE.
Example 2: Overseas AE as Toll/Contract Manufacturer & Indian AE as Principal
Consider an example where an overseas AE is a Toll/Contract manufacturer and Indian AE is the principal. In such a case, overseas AE would be the least complex entity for which the data would be readily available and hence it should be selected as a tested party.
On the other hand, if Indian AE is selected as a Tested Party, it must be making unique contributions for which comparables may not be readily available.
Moreover, if the Indian AE is selected as a tested party, it will not be possible to select CPM (Cost Plus Method) as the Most Appropriate Method, which depending on the other factors can be selected as a MAM in case of overseas AE.
Onus on Assessee
The onus is on the assessee to provide reliable data in respect of comparables of overseas AE. Practically, the assessee may face difficulty in obtaining the data from its overseas AE’s. However, if the assessee is not able to provide reliable data to the TPO/AO, the overseas AE cannot be selected as a tested party.
Conclusion
There is no express bar in the Indian Income Tax law against selection of the overseas AE as a tested party. However, the assessee should prepare a robust FAR analysis capturing the accurate functional profile of the overseas AE demonstrating how it is the least complex entity and how reliable data regarding the same is available. It should be well documented in the Transfer Pricing Study report as well as the master file of the assessee.