Range Concept: Less Litigation?

Litigation on transfer pricing issues has reached humongous proportion in India. The existing law of the use of arithmetic mean for determination of arm’s length price can be credited as a major igniter of such litigations as arithmetic mean had a tendency to be skewed by outlier comparables. Considering this limitation, the Hon’ble Finance Minister announced the introduction of ‘range’ concept in his speech while presenting Budget 2014. Consequently, Finance (No. 2) Act, 2014 amended section 92C(2) of the Income Tax Act, 1961 (‘the Act’) to provide for application of ‘range’ concept in cases where most appropriate method provided more than one arm’s length price (‘ALP’) for transactions entered into on or after April 1, 2014.

However, the guidance on the application of ‘range’ concept for determination of ALP was eagerly awaited by various interest groups. Finally, on May 21, 2015, Central Board of Direct Taxes (‘CBDT’) notified a draft scheme in relation to the same. The same is open for suggestions/ comments from stakeholders and general public until May 31, 2015.

The key highlights of the proposed mechanism are:

– ‘Range’ concept shall be used only in cases where Transactional Net Margin Method (‘TNMM’), Resale Price Method (‘RPM’) or Cost Plus Method (‘CPM’) applied

– Minimum of 9 comparable entities, based on functions, assets and risk analysis, are required

– 3-year data of these 9 entities (or more) would be considered and the weighted average of such 3-year data of each comparable entity would be used to construct the data set. However, use of data for 2 years instead of three permitted in cases where data of current year is not available or a comparable fails the quantitative filter for any one out of the three years or a comparable has commenced operations only in the last two years or has closed down the operations during the current year

– For determining the weighted average, the numerator and denominator of the chosen Profit Level Indicator (‘PLI’) would be aggregated for all the years for every comparable entity and thereafter, the margin would be computed

– The arm’s length range would be defined as the data points lying within the 40th to 60th percentile of the data set (which would have a minimum of 9 data points). No transfer pricing adjustment to be made in cases where transfer price falls within this range.

– In cases where transfer price falls outside the above range, the median of the range would be taken as ALP and adjustment to transfer price to be computed accordingly. There shall not be two different data sets – one for testing and one for making adjustments

The proposed scheme will surely cheer stakeholders. However, there are some critical points to look out for when the final scheme will be notified. The Indian Government has disregarded the global norm for using 25th to 75th percentile as range, and has proposed a range between 40th and 60th percentile. Some suggestions/ comments might be pointed in this direction and there maybe demands for modification of ‘range’ to align it with globally accepted practice. Another concern likely to be raised by companies and transfer pricing experts is on possible reasons for not extending the benefit of ‘range’ concept to ‘Profit Split Method’ as well as to ‘Other Method’ and restricting its application to only 3 methods, namely, TNMM, RPM and CPM.

It is also important for the Government to provide clarity on the approach to be adopted in cases where comparable entities are decreased beyond the specified limit of 9 comparable during assessment proceedings. The question is whether the taxpayer loses its right to apply the ‘range’ concept and moves back to ‘arithmetic mean’ concept at the time of audit. The Government should make adequate provision in this regard to ensure benefit of ‘range’ is enjoyed by the tax payers in its true spirit and tax authorities do not resort to the erstwhile practice of cherry picking of comparable entities which may ultimately lead to denial of the benefit of ‘range’ concept.

Questions are likely to be raised on the intention behind using the words “There shall not be two different data sets – one for testing and one for making adjustments”. Could it mean that tax authorities cannot resort to their own benchmarking exercise during audit, or that 2 search procedures, one adopted by the taxpayer and the other by the tax department cannot be merged? It is pertinent that the Government clarifies the same before the same gives rise to another round of litigation.

Also, finding adequate number of comparable entities has always been a challenge for the taxpayer. Though adequate number may be available in certain cases, there are instances where identifying a good set of comparable entities proves to be unfruitful and tedious exercise. Accordingly the proposal of use of at least 9 comparable for the benefit of ‘range’ concept would be questioned by the taxpayers.

The proposed scheme is likely to generate some debate. In the backdrop of heavily litigated environment, how beneficial will the ‘range’ concept prove and how successful will it be in its objective of reducing the same, is something which will depend upon how final scheme is framed by the Indian Government.

However, it is not wrong to say that the current approach of the Government of seeking stakeholder and general public comments on the draft scheme is clearly a collaborative approach. The fact remains that ‘range’ concept will help in development of Indian TP Regulations. It is certainly a positive step and in line with the best practices followed globally. The clarity on the certain issues would definitely help Indian transfer pricing environment to move towards a more mature and stable stage where there is a higher degree of mutual trust and confidence between the tax payer and tax authorities.