Selection Of Tested Party For The Purpose Of Transfer Pricing, An Issue Which Requires Consideration Of A Special Bench

Advocate P. C. Yadav has pointed out there is presently a conflict of opinion amongst the various Benches of the Tribunal as to the correct interpretation of the term “tested party” in the Transfer Pricing regulations read with the OECD Guidelines. The ld. author has explained the genesis of the conflict and requested that it should be resolved speedily, preferably by a judgement of the Special Bench

1. In my earlier Article, I have deliberated on the selection of most appropriate method for computing the ALP of an international transaction or international transactions. Now upon the huge demand of my followers and loved ones I am making this Article, which is the next step in Transfer pricing and plays an important role in studying the Transfer Pricing law. This is known as selection of the tested party in an international transaction.

2. So far as the selection of tested party is concerned, it is of utter importance to identify the entity that is to be the point of reference or known as “tested party”, since the entire transfer pricing exercise is based only on comparing the margin etc. of the ‘tested party’ with the average margin of comparables. The exercise of selection of tested party would always precede the process of selection of comparables. Because the whole purpose of the TP study is to test check the credibility of the profits of ‘tested party’. Though Transfer Pricing regulations (TPR) do not lay down any specific procedure or guidelines vis-a-vis the selection of the tested party, yet there are some guiding factors which are present in OECD and US, TPR.

3. The OECD guidelines provide that a tested party ought to be the enterprise that offers a higher degree of comparability vis-a-vis uncontrolled transaction. This is one line of thinking. Para-3.18 of OECD guidelines is extracted hereunder for the ease of reference. 

“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.”

4. A perusal of the above guidelines when read with the judgment rendered by the Indian Courts, it emerges clearly that the entire thrust of the OECD guidelines vis-v-vis tested party is that it should be least complex party.  Relevant Judgments wherein this interpretation has been upheld by the various India Courts are referred hereunder in subsequent Para(s).

5. The US Treasury Regulations as envisaged under 1.482 is reproduced hereunder, which defined “tested party”.

“The tested party will be the participant in the controlled transaction whose operating profit attributable to the controlled transactions can be verified using the most reliable data and requiring the fewest and most reliable adjustments, and for which reliable data regarding the uncontrolled comparables can be located. Consequently in most cases the tested party will be least complex of the controlled taxpayers and will not own valuable intangibles property or unique assets that distinguish it from potential uncontrolled comparables”

6. A perusal of the US regulations would show that in addition to the feature of being least complex party, a further rider that is ownership of intangibles or unique assets is also to be considered and the parties who have huge intangibles would required to be excluded since the presence of intangible asset makes them complex parties.  

7. Under the provisions of Indian Income Tax Act, to understand the concept of “tested party” one has to look at the provisions of section 92B of the Act and rule 10B (1) the Rules.

8. The provisions of Section 92B of the Act are as under:-

 (1) For the purposes of this section and sections 92, 92C, 92D and 92E, "international transaction" means a transaction between two or more associated enterprises, either or both of whom are non-residents, in the nature of purchase, sale or lease of tangible or intangible property, or provision of services, or lending or borrowing money, or any other transaction having a bearing on the profits, income, losses or assets of such enterprises, and shall include a mutual agreement or arrangement between two or more associated enterprises for the allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to be provided to any one or more of such enterprises.

(2) A transaction entered into by an enterprise with a person other than an associated enterprise shall, for the purposes of sub-section (1), be deemed to be an international transaction entered into between two associated enterprises, if there exists a prior agreement in relation to the relevant transaction between such other person and the associated enterprise, or the terms of the relevant transaction are determined in substance between such other person and the associated enterprise where the enterprise or the associated enterprise or both of them are non-residents irrespective of whether such other person is a non-resident or not.

Explanation.—For the removal of doubts, it is hereby clarified that—
  (i) the expression "international transaction" shall include—
  (a) the purchase, sale, transfer, lease or use of tangible property including building, transportation vehicle, machinery, equipment, tools, plant, furniture, commodity or any other article, product or thing;
  (b) the purchase, sale, transfer, lease or use of intangible property, including the transfer of ownership or the provision of use of rights regarding land use, copyrights, patents, trademarks, licences, franchises, customer list, marketing channel, brand, commercial secret, know-how, industrial property right, exterior design or practical and new design or any other business or commercial rights of similar nature;
  (c) capital financing, including any type of long-term or short-term borrowing, lending or guarantee, purchase or sale of marketable securities or any type of advance, payments or deferred payment or receivable or any other debt arising during the course of business;
  (d) provision of services, including provision of market research, market development, marketing management, administration, technical service, repairs, design, consultation, agency, scientific research, legal or accounting service;
  (e) a transaction of business restructuring or reorganisation, entered into by an enterprise with an associated enterprise, irrespective of the fact that it has bearing on the profit, income, losses or assets of such enterprises at the time of the transaction or at any future date;
 (ii) the expression "intangible property" shall include—
  (a) marketing related intangible assets, such as, trademarks, trade names, brand names, logos;
  (b) technology related intangible assets, such as, process patents, patent applications, technical documentation such as laboratory notebooks, technical know-how;
  (c) artistic related intangible assets, such as, literary works and copyrights, musical compositions, copyrights, maps, engravings;
  (d) data processing related intangible assets, such as, proprietary computer software, software copyrights, automated databases, and integrated circuit masks and masters;
  (e) engineering related intangible assets, such as, industrial design, product patents, trade secrets, engineering drawing and schema-tics, blueprints, proprietary documentation;
  (f) customer related intangible assets, such as, customer lists, customer contracts, customer relationship, open purchase orders;
  (g) contract related intangible assets, such as, favourable supplier, contracts, licence agreements, franchise agreements, non-compete agreements;
  (h) human capital related intangible assets, such as, trained and organised work force, employment agreements, union contracts;
  (i) location related intangible assets, such as, leasehold interest, mineral exploitation rights, easements, air rights, water rights;
  (j) goodwill related intangible assets, such as, institutional goodwill, professional practice goodwill, personal goodwill of professional, celebrity goodwill, general business going concern value;
  (k) methods, programmes, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data;
  (l) any other similar item that derives its value from its intellectual content rather than its physical attributes.

9. The mechanism for determining the ALP under the TNM method has been enshrined in clause (e) of rule 10B(1), which runs as under :

‘(i) the net profit margin realised by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base ;
(ii) the net profit margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base ;
(iii) the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market ;
(iv) the net profit margin realised by the enterprise and referred to in sub-clause (i) is established to be the same as the net profit margin referred to in sub-clause (iii) ;
(v) the net profit margin thus established is then taken into account to arrive at an arm’s length price in relation to the international transaction.’

10. The land mark cases on the issue of selection of tested party are as under:-

1. Gyr Limited (ITA Nos I.TA No. 37/Kol/2012, Assessment Year: 2007-08, & I.TA No. 1623/Ko1/2012 = 2016-TII-419-ITAT-KOL-TP :-  the Associated Enterprises of the assessee should be selected as tested party to the transaction, as being the least complex entity.
2. General Motors India Private Limited, in I.T.A. Nos. 3096/Ahd/2010 and 3308/Ahd/2011 = 2013-TII-162-ITAT-AHM-TP, wherein the tribunal has concluded that the foreign AE should be considered as the tested party being the least complex of the transacting entities and has relied on the UN TP Manual and various judicial precedents on this issue
3. Ranbaxy Laboratories Ltd. v. Additional Commissioner of Income-tax, Range-15. New Delhi [110 ITD 428] = (2008-TIOL-75-ITAT-DEL) wherein the ld. Tribunal held that, "that ld. CIT failed to appreciate that under the transfer pricing mechanism "tested party" out of two parties of a multinational involved in the transaction, that least complex party not owning intangible assets is to be taken as a tested party. The taxpayer had placed sufficient material on record to show that taxpayer was a complex party whereas other associated enterprises were less complex….
4. Development Consultant Private Limited reported in 2008-TIOL-150-ITAT-KOL:- It has been held that it is first necessary to select the ‘tested party’ and the tested party will be the least complex of the controlled taxpayer and will not own valuable intangible property or unique assets that distinguish it from potential uncontrolled comparables. The ITAT has accepted the selection of overseas affiliate as the tested party.
5. Global Vantedge Private Ltd 2008- TIOL 24-( By late C. L. Sethi Jee one of the stalwart of the ITAT):- It has been held that FAR should be given due importance for comparability and selection of the tested party would be normally the least complex entity provided sufficient reliable data is available.
6. Recently Hon’ble Kolkata Tribunal in the case of ALMATIS ALUMINA PVT LTD ITA No 726 of 2017 dated 16.04.2019 has held that since the AE is least complex party the assessee is correct in choosing the same as tested party 

11. In all above cases it has been unanimously held that the least complex party is to be taken as tested party. However story does not end here, Pune bench of the ITAT recently in the case of Eaton Industrial in ITA No 505 of 2015 reported in 2020-TII-154-ITAT-PUNE-TP has observed as under, after considering the provisions of Indian Transfer Pricing has observed as under:-

“ A tested party is a party in whose hands a transaction between the two related enterprises is tested vis-à-vis other comparable uncontrolled transactions for ensuring that is not structured in such a way so as to deprive the Indian exchequer of the rightful tax due to it. In case, profit rate of the tested party turns out to be less on a comparative analysis, then subject to other provisions, an upward increase in the profit of the Indian entity is made pro tanto. Now the question arises as to whether the foreign/Associated Enterprise(s) can be considered as tested party or only the Indian entity, which has recorded the transaction in its books of account, can be so considered.(Para13)

12. Thereafter Hon’ble Bench has referred to section 92B, and Rule clause(e) of Rule 10B(1) and held as under:-

“Provisions of the Chapter-X of the Act with the caption "Special Provisions Relating to Avoidance of Tax" dealing with the computation of income from international transactions having regard to ALP. Section 92(1) of the Act provides that : ‘Any income arising from an international transaction shall be computed having regard to the arm’s length price’. Thus, this provision applies to income of an enterprise from an international transaction, which is chargeable to tax under the Act. The term "international transaction" has been defined in section 92B to mean ‘a transaction between two or more associated enterprises, either or both of whom are non-residents, in the nature of purchase … of tangible …. property…..’. The methodology for computation of arm’s length price of an international transaction has been set out in section 92C(1) of the Act to be as per any of the prescribed methods, including the TNM method” (para14)

It has been further observed in Para (15), which in my opinion a must read Para to understand the concept of Transfer pricing, what is Enterprises, what is Associated Enterprises and how these terms are related to expression “tested party”

“The term ‘enterprise’ under the TNM method, and for that matter all other methods, has been used to indicate the assessee in whose hands the benchmarking of the international transaction is done and the term ‘associated enterprise’ has been used to denote the foreign/AE, being the other related party to the international transaction. It is so borne out from rule 10B(1)(b)(i) under the Resale price method, which provides that : ‘the price at which property purchased …. by the enterprise from an associated enterprise is resold…is identified’. As this method is usually applied in the hands of the party purchasing the goods and then reselling it, there remains no doubt that the term ‘enterprise’ has been used for the Indian assessee purchasing the goods for resale and the term ‘associated enterprise’ has been used for a seller foreign/AE. Coming back to the TNM method, rule 10B(1)(e)(i) provides that the net profit margin ‘realised by the enterprise’ from an international transaction entered into ‘with an associated enterprise’ is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base, which is then compared with the net profit margin realized by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction. The modus operandi of determining the ALP of an international transaction under this method is that, firstly, the profit rate realized or earned by the assessee from a transaction with its AE is determined (say, profit A), which is then compared with the adjusted rate of profit of comparable cases (say, profit B) so as to ascertain if ‘profit A’ is at arm’s length vis-à-vis ‘profit B’. If it is not, then, an addition on account of transfer pricing adjustment, subject to other provisions, is made in the hands of the assessee 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, insofar as calculation of ‘profit A’ is concerned, the same has to necessarily result in the hands of the assessee-enterprise (Indian entity) only from the transaction between two or more associated enterprises, as is the mandate of section 92 read with section 92B in juxtaposition to rule 10B. (Emphasis required)The natural corollary which, ergo, follows is that under no situation can the calculation of ‘profit A’ be substituted with anything other than the profit realized or earned by the assessee-enterprise from the international transaction. So, under the TNM method, it is the net profit margin realized by the Indian assessee-enterprise from the transaction with its foreign/AE, which is compared with that of the comparables. There can be no question of substituting the profit realized by the Indian enterprise with the profit realized by the foreign/AE for the purpose of determining the ALP of the international transaction of the Indian enterprise with its foreign AE. Scope of transfer pricing addition under the Indian taxation law is limited to transaction between the assessee and its foreign/ AE. We fail to comprehend as to how the profit realized by the foreign/AE can be relevant, when the profit of the Indian enterprise is sought to be ensured at ALP. The underlying object of the transfer pricing provisions is, inter alia, to see that there is no profit shifting from the Indian taxation base by means of the foreign/AE charging more than that charged by comparable independent cases, which fact is ensured by determining the ALP of the international transaction. If foreign/AE has, in fact, charged more, then its profit rate will shoot up and the corresponding profit of the Indian enterprise will be squeezed. In that scenario, a comparison of the profit rate of the foreign/AE will run contrary to the mandate of the provisions. Whereas, we were required to determine if the profit charged by the foreign/AE is not more than that charged by uncontrolled comparables by seeing the profit rate of the Indian enterprise, we will end up doing a futile exercise of rather viewing the profit rate of the foreign/AE, if such foreign/AE is taken as a tested party for the purposes of comparison with the profit rate of the comparables. Suppose the foreign/AE has charged more, then its profit rate will turn out to be higher, which when compared with the lower rate of profit margin of foreign comparables, will show the transaction at ALP, calling for no transfer pricing adjustment. This exercise is not only off the mark, but also runs counter to the rule and spirit of the transfer pricing provisions. Therefore as per the provisions of section 92 the tested party would always be the Indian Enterprises.”(Para-15)

13. The above ruling is in contrast to the other rulings on the subject, as in all other cases it has been held that least complex party would have to be selected as tested party be it AE or Indian Entity. Therefore now two views are there on this issue and hence unless any High Court would resolve it or a special bench is constituted the issue would be debatable.

14. With this I would end my Article and made a humble request to all my seniors and fellow colleagues that please comment on my article and give your esteemed suggestions so that I would improve my next article, which would be on selection of Comparables.

15. At last the above Article is dedicated to my seniors and stalwart members of the ITAT like late Shri C. L. Sethi (JM) late Shri Vimal Gandhi (JM), Shri P.K. Bansal (AM), Shri IC Sudhir (JM), Shri Abhrahim Gorege (AM) all are retired now.

16. I would also thankful to AIFTP a unique organisation of India and plays an important role in the Administration as well as adjudication of Indian Tax laws.

Jai Hind Jai Bharat