Transfer Pricing & The Law Of Selecting Comparables

Shri. K. C. Singhal, former Vice President of the ITAT, has carefully analyzed the judgement of the Delhi High Court in Chryscapital Investment Advisors (India) (P) Ltd vs. CIT [2015] 56 taxmann.com 417 (Delhi) and explained the law relating to the selection of comparables in the context of section 92C and Rule 10B

There had always been a dispute between the revenue and the assessees as to which comparables should be included or excluded while determining the ALP u/s 92C of the Income Tax Act 1961 (hereafter called the ‘Act’). What factors should be taken into consideration while selecting such comparables had been the core issue before the appellate authorities. Various decisions have been delivered by the hon’ble Tribunal on this issue. Recently, the hon’ble Delhi high court had to consider such issue in the case of Chryscapital Investment Advisors (India) (P) Ltd vs. CIT [2015] 56 taxmann.com 417 (Delhi) and such decision is of great significance on such issue.

Two major issues were raised before the hon’ble court, firstly, whether multiple year data or single year data should be used while selecting comparables for the purpose of determining the ALP under TNMM. The assessee had applied TNMM for determining the ALP and used the multiple year data of three years while the TPO used the single year data relating to the year under consideration; secondly whether entities having abnormal profits or losses should be excluded from the list of comparables. The contention of the assessee was that because of fluctuation in the margins of the comparable entities, multiple year data of the comparables was warranted to remove the effect of year specific aberrations. According to the assessee, such method was in consonance with the provisions of Rule 10B(4) and OECD guidelines. On second issue, it was contended that entities earning “super normal” or “abnormal” profits should be excluded from the list of comparables in view of several decisions of the tribunal including the decision of special bench. On the other hand, TPO selected comparables showing abnormal profits by using single year data and made adjustments in determining the ALP. The additions made by AO based on TPO report were sustained by the CIT(A) as well as the Tribunal.

At this stage, it is pointed out that the TPO included three entities as comparables which had very high profit margins as compared with that of the assessee. These entities namely, Brescon Corporate Advisors Limited (“Brescon”) (Operating Margin of 87.4%), Keynote Corporate Services Limited (“Keynote”) (Operating Margin of 191.58%) and Khandwala Securities Limited (“Khandwala”) (Operating Margin of 80.79%) had exceptional profit margins as compared with the Assessee (Operating Margin of 27.05%) and rejected three other comparables selected by the assessee (i.e. IDFC Investment Advisors Ltd. (17.35%), Sumedha Fiscal Services Limited (9.14%) and Future Capital Holdings Limited (20.56%).

The contention of the assessee’s counsel before the hon’ble high court was as under—

• That Brescon and Keynote should be excluded from the list of comparables as its (the assessee’s) risk profile is not similar to that of those two companies. They are risk-taking entities whereas the assessee operates on a cost plus model wherein a guaranteed return of 25% on costs is assured to it.

• That its functional profile is significantly different from that of Keynote. Unlike the assessee, Keynote is involved in capital market activities, including lead managing IPOs, Rights Offers, Buybacks and Takeovers. Also, Keynote considers its activities to be a Merchant Banker as evidenced by its Director’s Report and Notes to Accounts of the concerned financial year. The assessee submits that in the audited financials of Keynote, there is no service-wise break-up of profits and therefore, the profitability of the advisory services segment (which may be considered similar to the services being rendered by the assessee) is not available to be compared with the assessee’s profitability. The assessee argues that Keynote’s profit margins have shown volatility over the years which could be attributed to abnormal business conditions and therefore Keynote should be rejected as a comparable altogether.

• That Rule 10-B of the Rules contemplates adjustment on account of functional and other differences. Hence, adopting of any method ultimately envisages comparison of like functions, transactions and enterprises. OECD guidelines were also pressed into service in support of such contention.

• Reliance was also placed on the proviso to Rule 10-B (4) and stated that though the mandate of the law is ordinarily to rely upon comparables’ data for the current year, in certain circumstances, it is possible for the authorities to rely on previous years’ data restricted to two previous years. This is to eliminate any distorted picture which might be the consequence of adherence to the contemporaneous data, like in the present case.

The contention of the revenue before the hon’ble high court was as under—-

• Referring to the Rule 10B it was submitted that price charged or paid for the property transferred or service rendered in the comparable transaction is relevant in case of CUP and re-sale price method while the cost of production incurred in respect of property transferred or services provided is relevant for cost plus method. However, there is no mention of any property transferred or services provided in case of TNMM. They are provided for other methods. He contended that the relevant Rule thus makes it clear that specific characterization of the property transferred or services is not relevant for TNMM and this position is in conformity with the relevant OECD guidelines which suggest that broad comparability of functions should be done for TNMM.

• That neither the Act, nor the Rule contemplate exclusion of relevant transactions of like enterprises, in any manner other than what is prescribed. It was argued here that a comparable cannot be removed from consideration merely because it suffers loss; likewise, a unit or enterprise which enjoys higher profit (than the assessee or a significantly high profit in the industry) or even one making a so called “super profit” too cannot be eliminated.

• Generally, both loss making units and high profit making units cannot be removed from the list of comparables unless, such removal is statutorily permitted by Rule 10-B (2) or (3). Counsel also submitted that this is also evident from a reading of Rule 10-C. It was pointed out that Rule 10B (3) (ii) and Rule 10 C (2)(e) permitted adjustment to eliminate material defects of the difference between the assessee and comparables. Counsel argued that only those factors which result in material difference in the comparables of transactions as between the assessee and the unrelated transaction or the third party enterprise, have to be reasonably adjusted to avoid distortions under the said provisions. The step envisioned there had to be necessarily followed keeping in view the mandate “shall”.

• That OECD guidelines cannot be applied because there are specific provisions of Rule 10B (2) & (3) and the first proviso to Section 92C(2) which apply. Reliance was placed on the decision of DHC in case of CIT v. Mentor Graphics (Noida) (P.) Ltd. [2013] 354 ITR 586.

Findings of the court

After referring to the provisions of Section 92C and Rule 10B as well as various decisions of the tribunal and decision of its own court, the hon’ble high court has held that provisions of the Act and Rules are supreme and therefore, ALP must be determined in accordance with such provisions. Hence, the OECD guidelines cannot be resorted to in preference over such provisions.

Since TNMM was selected as most appropriate method (MAM) u/s 92C by the assessee as well as the TPO, it was held that comparables had to be selected as per Rule 10B. . It would be appropriate to refer to the relevant findings in paras 31, 32, 33, 35, 37 of the judgment—-

1. Where the arm’s length price of the international by the assessee is to be determined by applying TNMM as MAM then, ALP must be determined with reference to the functions performed, taking into account the assets employed or to be employed and the comparability the risks assumed by the respective parties to the transaction as per rule 10B(2)(b). [para 31]

2. The specific characteristics of the property transferred or services provided (contemplated by Rule 10B(2)(a)) in either transactions may be secondary, for judging comparability of an international transaction in the TNMM, because the price charged or paid for property transferred or services provided and the direct and indirect cost of production incurred by the enterprise in respect of property transferred or services provided go into reckoning comparability analysis in the transaction methods, i.e the comparable uncontrolled price, resale price and cost plus whereas the profit based method such as transactional net margin method takes into account, the net margin realised.[para 31]

3. Rule 10B(3) mandates that a given or select uncontrolled transaction selected in terms of Rule 10B(2) “shall be comparable to an international transaction” if none of the differences, if any, between the compared transactions, or between enterprises entering into such transactions “are likely to materially affect the price or cost charged or paid or the profit arising from such transaction in the open market or reasonably accurate adjustment can be made to eliminate the effects of such difference.[para 31]

4. The sequitur of Rule 10B (2) and (3) is that if the comparable entity or entity’s transactions broadly conform to the assessee’s functioning, it has to enter into the matrix and be appropriately considered.[para 32]

5. The other exercise which the TPO has to necessarily perform is that if there are some differences, an attempt to “adjust” them to “eliminate the material effects” should be made.[para 32]

6. Such being the case, it is clear that exclusion of some companies whose functions are broadly similar and whose profile – in respect of the activity in question can be viewed independently from other activities-cannot be subject to a per se standard of loss making company or an “abnormal” profit making concern or huge or “mega” turnover company. [para 33]

7. Rule 10B (3) on the other hand, indicates the approach to be adopted where differences and dissimilarities are apparent. Therefore, the mere circumstance of a company – otherwise conforming to the stipulations in Rule 10B (2) in all details, presenting a peculiar feature – such as a huge profit or a huge turnover, ipso facto does not lead to its exclusion. The TPO, first, has to be satisfied that such differences do not “materially affect the price…or cost”; secondly, an attempt to make reasonable adjustment to eliminate the material effect of such differences has to be made. [para 33]

8. As regards the relevance of multiple year data for transfer pricing determination, this Court is of the opinion that the general rule as prescribed in Rule 10B(4) mandates the tax authorities to take into account only the relevant assessment year’s data. [para 35]

9. The proviso to Rule 10B(4) permits data relating to two years prior to the relevant assessment year to be taken into account in the event that they have an influence on the determination of price. However, in such instances, the onus lies upon the assessee to establish the relevance of such data. The language of Rule 10B(4) does not leave any scope for ambiguity on this issue. [para 35]

10. The Guidelines, have of OECD therefore only persuasive status; they do not have any legal sanction- unlike, for instance Double Taxation Avoidance Agreements which courts are duty bound to interpret and implement, in terms of municipal law, given the compulsion of provisions of the Income Tax Act.—- – the provisions of the Constitution compel a national legislation, to embody the terms of a treaty, for it to be enforceable in courts in India. This is because of Article 253 of the Constitution and the dualist tradition (of International law) followed by India, whereby treaties by themselves are legally unenforceable in courts, but are to be assimilated through municipal (or national) legislation.— Thus, the Courts are primarily bound by the law on the subject in India; if the law is clear and unambiguous, there is no question of resorting to extrinsic sources. The only rider is that if the terms of such conventions or treaties are similar to the law applicable in India, courts may consider precedents in that regard; however those are only of persuasive value. The reliance was placed on its earlier decision in Mentor Graphics (P.) Ltd. 354 ITR 586(Delhi) [para 37-38]

11. In any event, the OECD Guidelines relevant herein are in consonance with the Rules. Para 3.63 of the Guidelines states that an extreme comparable cannot be excluded “on the sole basis that the results arising from the proposed ‘comparable’ merely appear to be very different from the results observed in other proposed ‘comparables’ and that “further examination would be needed to understand the reasons for such extreme results”.[para 38]

12. Similarly, para 3.65 states that “loss-making comparables that satisfy the comparability analysis should not however be rejected on the sole basis that they suffer losses”. Further, para 3.64 states that “it is the facts and circumstances surrounding the company in question that should determine its status as a comparable, not its financial result”. The same approach is prescribed in para 3.66 for entities making supernormal profits. Therefore, both the OECD Guidelines as well as Rule 10B (2) and 10B (3) do not, in any manner, prescribe automatic exclusion of entities with extreme financial results. [para 38}

13. Similarly, insofar as the use of multiple year data is concerned, Para 3.75 of the OECD Guidelines states that “[m]ultiple year data should be used where they add value to the transfer pricing analysis.” This is akin to the proviso to Rule 10B(4) which provides for “data relating to a period not being more than two years prior to such financial year [to] be considered if such data reveals facts which could have an influence on the determination of transfer prices in relation to the transactions being compared.” [para 38]

14. In the present case, this Court holds that once Brescon, Keynote and Khandwala Securities are held to be functionally similar to the assessee, they would be included as comparables, notwithstanding their high profit margins, provided that the material difference on account of such high profit margins can be eliminated under the Rule 10B(3) analysis. [Para 40]

15. However, in respect of Keynote, the court noted that services provided by the assessee were quite different from the services provided by the Keynote and therefore Keynote could not be considered as comparable one. The court also held that keynote could not be included in list of comparable merely because it was included by the assessee itself. [para 42]

Impact of the judgment

This judgment is of great significance on various aspects relevant for determining the ALP u/s 92C by applying TNMM as most appropriate method. Firstly, it lays down that provisions in the Act & Rules are supreme and therefore, the OECD guidelines cannot be pressed in to service while determining the ALP u/s 92C. The reason given in para 37 is that it has no legal sanction since India is not party to it unlike DTAAs which have legal sanction by virtue of provisions in the Income Tax Act 1961. The only rider is that if the terms of such conventions or treaties are similar to the law applicable in India, courts may consider precedents in that regard; however those are only of persuasive value. Thus, the effect of this legal position is that the ALP must be determined in accordance with the provisions of the Act & the Rules made thereunder.

Secondly, it lays down that ALP must be determined only on the basis of single year data as provided in Rule 10B(4). The proviso to this Rule would be applicable only in exceptional cases where data reveals facts which can have an influence on determination of transfer prices in relation to the transaction being compared. The onus would be on the person invoking the provisions of the proviso.

Thirdly, where TNMM is considered as most appropriate method, the ALP has to be determined in accordance with the provisions of Rule 10B. Thus, firstly, ALP must be determined with reference to the functions performed, taking into account the assets employed or to be employed and the risks assumed by the respective parties to the transaction as per rule 10B(2)(b). The specific characteristics of the property transferred or services provided (contemplated by Rule 10B(2)(a)) in either transactions may be secondary. If the comparable entity or entity’s transactions broadly conform to the assessee’s functioning, it has to enter into the matrix and be appropriately considered. The other exercise which the TPO has to necessarily perform is that if there are some differences, an attempt to “adjust” them to “eliminate the material effects” should be made.

As a result thereof, the entit1es making high/extremely high profits/losses will not, ipso facto, lead to its exclusion from the list of comparables for the purposes of determination of ALP since such factor is not covered the provisions of Rule 10B. In such circumstances, an enquiry under rule 10B(3) ought to be carried out, to determine as to whether the material differences between the assessee and the said entity can be eliminated. If such exercise is not warranted then the entity should be included as a comparable.

In view of such legal finding, all the decisions of the tribunal directing the exclusion of the entities declaring abnormal profits or showing losses stand disapproved in the absence of any other decision of any high court or the apex court.

Lastly but not the least, where any comparable is included by the assessee in its transfer pricing study and intends to exclude the same before the tax authorities, the TPO cannot refuse such request if otherwise is not comparable under the Rules. This finding is based on the principle that there is on estoppel against the law. In the present case, entity “Keynote” was included by assessee but later requested TPO to exclude the same on the ground that functionally, it was different from the assessee’s entity. The court has held that TPO could not refuse such request merely because it was included by the assessee itself.

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