India: SKP Transfer Pricing 360˚ – Volume 3 Issue 3 | Oct-Dec 2016

Selection of Foreign Company as a tested party – practical considerations

Introduction
Transfer pricing regulations adopted by India are based on the arm’s length principle which revolves around the concept that the price or margin determined in a controlled transaction involving two Associated Enterprises (AE) should be commensurate with an uncontrolled transaction between two independent enterprises operating under similar circumstances. The process of identification of uncontrolled comparables and consequently, the arm’s length price (ALP), is known as the ‘comparability analysis’ and consists of two steps, namely the functional analysis and the economic analysis.
The functional analysis (also called FAR analysis) involves the analysis of functions carried out, assets used and risks assumed by the AE involved in the international transaction. The FAR analysis helps in characterising the roles of the entities involved in the transaction under examination, which is the backbone for carrying out the economic analysis in order to determine the ALP for the transaction.
Economic analysis typically starts with the selection of the ‘tested party’ amongst the transacting entities, determining the ‘most appropriate method’ and ‘profit level indicator’ and finally, the determination of the arm’s length price or margin.
Except for price based methods (Comparable Uncontrolled Price method and other method), where the price of the goods or services transacted is considered, under all other methods it is profit which is taken up for arriving at the ALP. In the methodologies requiring the determination of profits, the transacting entity whose profit margin is taken up for comparison is called the ‘tested party’. Identification of the tested party is crucial as that determines the selection of comparables and thereby, the ALP.
However, selection of the tested party is a matter of uncertainty and litigation in India as the Indian transfer pricing regulations do not define the concept of a ‘tested party’.

Concept of tested party
The Organisation for Economic Co-operation and Development (OECD) in the ‘Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations’, states:

Chapter III – Comparability Analysis
Paragraph 3.18 “When applying a cost plus, resale price or transactional net margin method, it is necessary to choose a tested party to the transaction for which a financial indicator (markup costs, gross margin or net profit indicator) is tested. 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 comparable can be found i.e. it will most often be the one that has the less complex functional analysis.”

Also, the ‘UN Practical Manual on Transfer Pricing’ (UN Manual) has dealt with this issue in great detail. The UN Manual defines tested party in a similar manner in para no.5.3.3.1 wherein it is stated the following:

“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 comparability is available. It may be the local or the foreign party”.

It is also pertinent to note that in the original as well as the recently revised UN Manual, in paragraph 10.4.1.3, the relevant paragraph discussing India’s TP Regulations, reads as under:

“———-the Indian transfer pricing administration prefers Indian comparable in most cases and also accepts foreign comparable in cases where the foreign AE is the less or least complex entity and requisite information are available about the tested party and comparable.”

The fact that India’s position about the selection of a tested party remains the same in the original as well as revised UN Manual shows the intention of the Indian government to accept a foreign AE as a tested party upon satisfaction of essential conditions.

• Based on these definitions, one can infer that the ‘tested party’ should have the following attributes;
• Least complex (amongst the parties to the transaction);
• Availability of reliable and accurate data for comparison; and
• Data available can be used with minimal adjustments.

Typical scenarios where a foreign entity should be the tested party
In situations where the Indian company is acting as a full fledged entrepreneurial entity and the foreign AE is acting with lesser functions/ assets/risks pertaining to the international transaction under consideration, it would be appropriate to consider the foreign AE as a tested party whose profit margin should be taken up for comparison/ benchmarking with the comparable transactions/entities.

In order to illustrate the above, take for example an Indian company (I Co) is engaged in software development and sales and mainly caters to customers situated in the US. It owns and uses valuable marketing and technical intangibles pertaining to the software development and sales business. The foreign company (F Co), situated in the US, is the AE of I Co and is engaged in providing marketing and sales support services to I Co in selling software and related services in the US market. F Co is remunerated on operating cost plus basis by the I Co for rendering the aforesaid support services.

With the facts above, I Co is an entrepreneurial entity performing larger functions in terms of software development and sales, carrying higher risks and utilising intangible assets while F Co is performing routine marketing/sales and liasoning activities for I Co’s software business. The tested party for such kinds of transactions would most often be F Co as it is the least complex entity based on functional analysis.

Thus, conceptually, the selection of the tested party is dependent on the nature of the international transaction and FAR profile of the entities involved in the international transaction.

Approach of the Indian tax authorities
There has been a mixed response from the tax authorities while dealing with the issue of selecting a foreign AE as a tested party during the transfer pricing assessment proceedings.

While in some cases the Transfer Pricing Officers (TPOs) have demonstrated their openness to accept a foreign AE as tested party wherever the same has been supported by a robust FAR analysis and the availability of appropriate data, in most cases, the TPOs seem to be rejecting this approach on the premise that such a position has no support under the Indian transfer pricing law or on the basis of unavailability of reliable data for analysis.

Judicial positions
Similar to the experience at lower level tax authorities, there are contrary views in the Indian judicial precedents about this crucial issue, although the majority favours the selection of a foreign company as a tested party if the facts of the case justify it.

A few important judgements accepting the selection of a foreign company as a tested party are presented below:

• Ranbaxy Laboratories Ltd v/s ACIT (ITA No.196/Del/2013)

In this case, the Income Tax Appellate Tribunal (ITAT) has also drawn support from the taxpayer’s Advance Pricing Agreement (APA) signed with the Central Board of Direct Taxes (CBDT) for Assessment Year (AY) 2014-15, wherein the CBDT approved the selection of foreign AEs as tested parties with Transactional Net Margin Method (TNMM) as the most appropriate method and also approved the concept of benchmarking when considering regional comparables.

•  Landis Gyr Limited (ITA No. 37/ Kol/2012 and ITA No. 1623/ Kol/2012)
•  General Motors India Private Limited (ITA No. 3096/Ahd/2010 and 3308/Ahd/2011)
• Global Vantedge P Ltd (ITA No. 2763 and 2764/Del/2009)
• Development Consultants (P) Ltd (ITA No.79/Kol/2008 and ITA No.80/Kol/2008)
• TNT India Pvt Ltd (ITA No. 1443/ Bang/08 and ITA No.1444/ Bang/08)

Also, there are few important judgements wherein a foreign AE as a tested party and the use of foreign comparables has not been permitted by the judicial authorities. The summary of these judgements is presented below:

•  AT & S India Pvt Ltd (ITA No.179/Kol/2016)

The ITAT rejected a foreign AE as a tested party on the ground that accounts of the AE were based on Austria General Accepted Accounting Principles (GAAP) and therefore, the method of accounting, allocation of costs, recognition of revenue, etc. were differed for making a proper comparison.

• GE Money Financial Services Private Limited (ITA No.440/ Del/2014)

The ITAT was of the opinion that using a foreign entity for benchmarking analyses does not have any sanctity within the Indian transfer pricing regulations.

• Aurionpro Solutions Ltd (ITA No. 7872/Mum/2011)

While rejecting the foreign entity as a tested party, the ITAT stated that under the transfer pricing provisions, the effect of the international transaction on the income/expense of the taxpayer should be considered and not that of the foreign AE.

• Onward Technologies Limited (ITA No.7985/Mum/2010 )

The ITAT was of the opinion that there is no provision within the Indian transfer pricing regulations for treating a foreign entity as a tested party and further stated that borrowing a contrary mandate from transfer pricing provisions of other countries is not permissible.

•  Sutherland Healthcare Solutions Ltd (ITA No.831/ Hyd/2009)

The ITAT rejected a foreign entity as a tested party in the absence of availability of sufficient information with respect to the foreign tested party and corresponding data of comparable companies.

Approach in Advance Pricing Agreements (APAs)
It is worthwhile to know that in some APAs concluded so far, the APA authorities have accepted the benchmarking analysis using foreign entities as a tested party on the basis of the FAR profile of the entities participating in the international transaction. Also, as a positive indication, as mentioned earlier, the benchmarking approach concluded in the APA has also been acclaimed by the Tribunal in the case of Ranbaxy Laboratories Ltd v/s ACIT.

Practical challenges in selection of a foreign entity as a tested party
Although considering a foreign AE as a tested party may satisfy the conceptual requirements based on the facts of the case, it is also worthwhile to ponder upon the practical challenges that may be posed during the transfer pricing analysis in terms of availability of accurate and reliable data of AEs and comparable companies operating in another jurisdiction. These challenges are mentioned below:

•  Access to and reliability of the foreign databases used for performing the search analysis;
• Non-availability of annual reports of the comparable foreign companies for verifying the business overview and financial data;
• Disparity in financial data i.e. difference in accounting year-end, accounting disclosure requirements or lack of course to validate the financial data on public databases; and
• Obtaining transaction specific sufficient data in a situation where the tested party is engaged in other lines of business apart from the international transaction being considered.

In light of the above, before determining whether the Indian company or the foreign AE should be selected as the tested party, both the factors, functional analysis of the transaction as well as the availability of reliable details needs to be taken into account.

Conclusion
The responsibility lies with the taxpayer to satisfy the tax authorities that the selection of a foreign entity as a tested party is based on a thorough functional analysis and reliable information with respect to the foreign AE and that comparable(s) is available for determining the ALP. It should be ensured that while preparing the transfer pricing documentation, all the requisite criteria for selection of the tested party are met and the requisite inter-company documents and details of the comparable(s) are maintained.

At the same time, the Indian government should clarify (within the transfer pricing regulations) that a foreign company can also be considered a tested party and possibly provide more guidance on this issue so that the legal hurdles faced by taxpayers can be mitigated.