CBDT unveils draft scheme of proposed rules for ALP

Indian Government has finally heeded the clarion call of the taxpayers who were besieged by transfer pricing adjustments.That said, while an earnest beginning has been made, it would bring the matter to a perfect close if the apparent deficiencies in the draft rules were to be addressed

Since its introduction in 2001, the Indian transfer pricing regulations have been a significant area of focus for both the tax department and taxpayers alike. In particular, in computing the arm’s length price, there have been two areas of primary concern which are as follows:
The current practice of computing the ALP in the Indian transfer pricing regulation is to use an arithmetic mean where more than one comparable price is identified. The use of arithmetic mean concept produces only one arm’s length price which is prone to being influenced by the outlier comparables (i.e. very high margin or very low margin comparable) and has accordingly been the one of the significant causes for high amount litigation in the transfer pricing domain in India. Relative to the said concept applied in India, the international practice is to apply a range concept, the intent being to provide a range of Arm’s Length Prices (“ALP”) or margins for assessing the compliance of the related party transactions with the arm’s length pricing requirements.

Further, currently tax payers prepare their transfer pricing documentation by using data for the prior two financials years for the comparable companies as the data for the relevant financial year is not available for most companies in the external databases at the time of undertaking of the benchmarking analysis. The current transfer pricing regulation allows the use of multiple year data conditionally, which is difficult to establish. Given the current restrictions, the tax authorities do not accept the use of multiple year data and the documentation maintained by the taxpayer are rejected by the tax authorities owing to use of multiple year data, and therefore paving the way for widespread ligation.

Now, after a long wait, the India’s Central Board of Direct Taxes (“CBDT”) on May 21, 2015 has issued a draft scheme on implementing the “range concept” and allowing a liberal use of multiple-year data for computing the arm’s length price of international transactions and of specified domestic transactions undertaken on or after 1 April 2014. The scheme is a result of the FM’s statement during Budget 2014, to align the transfer pricing provisions in India with international practices.

Briefly, it is proposed that the Range concept and the use of multiple year data for determination of ALP will be allowed where transaction net margin method (TNMM), resale price method (RPM) or cost plus method (CPM) is used for undertaking the benchmarking analysis. The scheme contemplates the use of a minimum of 9 comparable companies for determination of the range. Further, the range is defined as being the 40th percentile to the 60th percentile. Should the aforesaid criteria not be fulfilled, the determination of arm’s length price will default to the arithmetic mean. As far as multi-year data is concerned, the use of two previous years in addition to the current year data, would be permitted freely.

The approach of the CBDT to issue a draft guidelines for public consultation reflects well on the intention of the revenue to follow an inclusive and a collaborative approach in framing the guidelines. While the intention of bringing the said change is to align the Indian transfer pricing regulations with the international practice, there are still certain shortcomings.

For one, the proposed range of between 40 percentile and 60 percentile is well short of the internationally accepted inter-quartile range. Another drawback is that the range and the multiple year data concept is kept away for tax payers who may be using Comparable Uncontrolled Price, or Residual Profit Split Method or even the Other Method for the purpose of determining the ALP. To illustrate, several data points constituting a range can be available in certain cases where CUP method is used, such as commodity prices, bullion prices, interest rates, brokerage rates, royalty agreements, etc. Finally, the minimum number of comparables at 9 is too high an ask. Transfer pricing documentation and orders in several industries end up with less than 9 comparables. And a change in the number of comparables could change the method of determining the price.

It is gladdening to see that the Indian Government has finally heeded the clarion call of the taxpayers who were besieged by transfer pricing adjustments. It is widely accepted that the amendment of the +/-3% tolerance band from the mean to the interquartile range and the use of multi-year data will take down litigation substantially. That said, while an earnest beginning has been made, it would bring the matter to a perfect close if the apparent deficiencies in the draft rules were to be addressed.